Name : Devi Nanda Bayti Rahma
NIM : C1B018095
Task : Summary Chapter 6
Government Influence On Exchange Rates
Exchange Rate Systems
Exchange rate systems can be classified according to the degree to which the rates are controlled by t
he government. Exchange rate systems normally fall into one of the following categories:
1. fixed
2. freely floating
3. managed float
4. pegged
Fixed Exchange Rate System
In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only
within very narrow bands.
Devaluation, Revaluation
The Bretton Woods era ( ) fixed each currency’s value in terms of gold.
The 1971 Smithsonian Agreement which followed merely adjusted the exchange rates and expanded
the fluctuation boundaries. The system was still fixed.
Pros: Work becomes easier for the MNCs.
Cons: Governments may revalue their currencies. In fact, the dollar was devalued more than once aft
er the U.S. experienced balance of trade deficits.
Cons: Each country may become more vulnerable to the economic conditions in other countries.
Freely Floating Exchange Rate System
In a freely floating exchange rate system, exchange rates are determined solely by market forces.
Pros: Each country may become more insulated against the economic problems in other countries.
Pros: Central bank interventions that may affect the economy unfavorably are no longer needed.
Pros: Governments are not restricted by exchange rate boundaries when setting new policies.
Pros: Less capital flow restrictions are needed, thus enhancing the efficiency of the financial market.
Cons: MNCs may need to devote substantial resources to managing their exposure to exchange rate f
luctuations.
Cons: The country that initially experienced economic problems (such as high inflation, increasing u
nemployment rate) may have its problems compounded.
Managed Float Exchange Rate System
In a managed (or “dirty”) float exchange rate system, exchange rates are allowed to move freely on a
daily basis and no official boundaries exist. However, governments may intervene to prevent the rate
s from moving too much in a certain direction.
Cons: A government may manipulate its exchange rates such that its own country benefits at the exp
ense of others.
Pegged Exchange Rate System
In a pegged exchange rate system, the home currency’s value is pegged to a foreign currency or to so
me unit of account, and moves in line with that currency or unit against other currencies.
The European Economic Community’s snake arrangement ( ) pegged the currencies of member coun
tries within established limits of each other.
The European Monetary System which followed in held the exchange rates of member countries toge
ther within specified limits and also pegged them to a European Currency Unit (ECU) through the ex
change rate mechanism (ERM).
The ERM experienced severe problems in 1992, as economic conditions and goals varied among me
mber countries.
In 1994, Mexico’s central bank pegged the peso to the U.S. dollar, but allowed a band within which t
he peso’s value could fluctuate against the dollar.
By the end of the year, there was substantial downward pressure on the peso, and the central bank all
owed the peso to float freely. The Mexican peso crisis had just began ...
Currency Boards
A currency board is a system for maintaining the value of the local currency with respect to some oth
er specified currency.
For example, Hong Kong has tied the value of the Hong Kong dollar to the U.S. dollar (HK$7.8 = $
1) since 1983, while Argentina has tied the value of its peso to the U.S. dollar (1 peso = $1) since 19
91.
For a currency board to be successful, it must have credibility in its promise to maintain the exchang
e rate.
It has to intervene to defend its position against the pressures exerted by economic conditions, as wel
l as by speculators who are betting that the board will not be able to support the specified exchange r
ate.
Exposure of a Pegged Currency to Interest Rate Movements
A country that uses a currency board does not have complete control over its local interest rates, as th
e rates must be aligned with the interest rates of the currency to which the local currency is tied.
Note that the two interest rates may not be exactly the same because of different risks.
Exposure of a Pegged Currency to Exchange Rate Movements
A currency that is pegged to another currency will have to move in tandem with that currency against
all other currencies.
So, the value of a pegged currency does not necessarily reflect the demand and supply conditions in t
he foreign exchange market, and may result in uneven trade or capital flows.
Dollarization
Dollarization refers to the replacement of a local currency with U.S. dollars.
Dollarization goes beyond a currency board, as the country no longer has a local currency.
For example, Ecuador implemented dollarization in
Government Intervention
Each country has a government agency (called the central bank) that may intervene in the foreign exc
hange market to control the value of the country’s currency.
In the United States, the Federal Reserve System (Fed) is the central bank.
Central banks manage exchange rates
to smooth exchange rate movements,
to establish implicit exchange rate boundaries, and/or
to respond to temporary disturbances.
Often, intervention is overwhelmed by market forces. However, currency movements may be even m
ore volatile in the absence of intervention.
Direct intervention refers to the exchange of currencies that the central bank holds as reserves for oth
er currencies in the foreign exchange market.
Direct intervention is usually most effective when there is a coordinated effort among central banks.
When a central bank intervenes in the foreign exchange market without adjusting for the change in m
oney supply, it is said to engaged in nonsterilized intervention.
In a sterilized intervention, Treasury securities are purchased or sold at the same time to maintain the
money supply.
Some speculators attempt to determine when the central bank is intervening, and the extent of the int
ervention, in order to capitalize on the anticipated results of the intervention effort.
Central banks can also engage in indirect intervention by influencing the factors that determine the v
alue of a currency.
For example, the Fed may attempt to increase interest rates (and hence boost the dollar’s value) by re
ducing the U.S. money supply.
Note that high interest rates adversely affects local borrowers.
Governments may also use foreign exchange controls (such as restrictions on currency exchange) as
a form of indirect intervention.
Intervention warning
Impact of Central Bank Intervention on an MNC’s Value
E (CFj,t ) = expected cash flows in currency j to be received by the U.S. parent at the end of period t
E (ERj,t ) = expected exchange rate at which currency j can be converted to dollars at the end of peri
od t
k = weighted average cost of capital of the parent
Direct Intervention
Indirect Intervention
