Lecture 11

Government Influence on exchange rate

Exchange rate systems.

 Exchange rate systems fall into the following categories.

 1.Fixed Exchange rate system.
 2.Freely floating exchange rate system.
 3.Managed floating system.
 4.Pegged exchange rate system.

 1. Fixed Exchange rate system.

 Exchange rate are either held constant or allowed to fluctuate only within
very narrow boundaries.
 If exchange rate move beyond boundaries, governments intervene to
maintain it within the boundaries.
 In some cases it will re-value the currency.
 In some cases it will de-value the currency.
1. Fixed Exchange rate system.

 Devaluation refers to a downward adjustment of the exchange rate.

 Re-valuation refers to an upward adjustment of the exchange rate.
 What is Bretton woods agreement???
 Exchanged rates were typically fixed according to this agreement.
 This agreement lasted from 1944-1971.
 Each currency was valued in terms of gold. For example, the US- dollar was
valued as 1/35 ounce of gold.
 Exchange rates drifted no more than 1% above or below the initially set rates.
 What is Smithsonian agreement???
 During Bretton Woods, the united States experienced a balance of trade deficit.
 This was an indication that the dollar value will be too strong.
1. Fixed Exchange rate system.

 The use of dollar for the foreign purchases exceeded the demand.
 In December 1971, the Smithsonian agreement took place.
 The dollar was devalued by 8 %.
 In addition the boundaries for the currency’s value were expanded to within
2.25% above or below the rates initially set by the agreement.
 Nevertheless international imbalances continued.
 By March1973, most countries governments left away the Smithsonian
agreement.
 Advantages of a fixed exchange rates.
 1. MNC’s are able to engage in international trade without worrying about
the future exchange rates.
 The managerial duties become less difficult. ( Example consult Book)
1. Fixed Exchange rate system.

 Disadvantage of Fixed exchange rate system.

 It is still risk that the government will alter the value of the currency.
 From macro point of view, the fixed exchange rate system may make each
country more vulnerable (unprotected) to economic conditions in other
countries.
 For example, two countries United States and United Kingdom.
 Assume a fixed exchange rate system.
 If US experiences a high inflation than that of UK.
 The US customers will shift towards UK goods and UK will reduce imports.
 In a result the unemployment will increase in US due to less goods demand.
 It could also cause in inflation in UK due to higher UK goods demand.
 As a result the Unemployment in UK will increase due to less demand.
 US was accused of exporting that inflation to other countries in mid 1960’s.
2. Freely floating exchange rate systems.
 In a freely floating exchange rate system, the exchange rate values are
determined by the market forces (demand and supply) without government
intervention.
 It allows complete flexibility.
 A freely floating exchange rate adjusts on a continual basis in response to
demand and supply conditions for that currency.
 Advantages of freely floating system.
 1. A country is more insulated (protected) from the inflation of other country.
 For example, if the United states experiences a high rate of inflation, the increased
US demand for British goods will place an upward pressure on the British Pounds.
 As a second consequence, the reduce British demand for the US goods will result
in reduce supply of Pounds (exchange for US-dollars) , that will also place an
upward pressure on the pounds (appreciation).
2. Freely floating exchange rate systems
 Advantages…. Continue……
 2. Another advantage of the freely floating exchange rate system is that a
country is more insulated from unemployment problems in other countries.
 3. An additional advantage of a freely floating exchange rate system is that a
Central Bank is not required to constantly maintain exchange rates within
specified bounds.
 Therefore, it is not forced to implement an intervention policy that may have an
unfavorable effect on the economy just to control exchange rates.
 Disadvantages
 1. It can be disadvantage for the country that initially experiences the
problems.
 For example, a weaker US dollar causes import prices to be higher, therefore
increasing the prices of the supplies and materials,
2. Freely floating exchange rate systems

 Thereby, increasing the prices of the finished goods.

 In addition, higher foreign prices (from the US perspective) can
force US consumers to purchase domestic products.
 US producer recognizes that his/her foreign competition has been
reduced due to weak dollar.
 So, they also raise the prices of their products without loosing their
customers to foreign competition.
 2. In a similar manner, a freely floating exchange rate system can
adversely affect a country that has high unemployment. (look the
example at book).
 What is Clean exchange rate system?????
3. Managed Float Exchange rate system

 This exchange rate system lies somewhere between the Fixed system and
freely floating system.
 It resembles to freely float system in that exchange rates are allowed to
fluctuate on a daily basis and there are no official boundaries.
 It resembles to fixed exchange rate system n that governments at some
time can and do intervene to prevent their currencies from moving too far in
a certain direction.
 This type of system is also called “ Dirty Float system”.
 For example, at times the governments of various countries including
Brazil, Russia, South Korea, and Venezuela have imposed bands around
their currencies.

 Why bounds?????????
 To limit their currency.
 They removed bands when they found they no longer maintain it.
3. Managed Float Exchange rate system

 Criticism on the Managed float system

 Critics suggest that a managed float system allows a government to
manipulate exchange rates that can benefits its own country at the expense
of the others,
 For example a government can weaken it home currency to stimulate a
stagnant economy.
 The increased aggregate demand from products that results from such a
policy(????) may result in decreased aggregate demand for other countries.
 Weakened currencies can attract foreign demands.
4. Pegged Exchange rate system.

 An arrangement in which home currency’s value is pegged to a foreign currency

(or some unit of account).
 Home country’s value is fixed in terms of the foreign currency (or unit of account)
to which it is pegged.
 It moves in line with that currency against other currencies.
 Some Asian countries like Malaysia and Thailand had pegged their currency’s
value to the dollar.
 During the Asian crises, they were unable to maintain the peg and allowed their
currencies to float against the dollar.
 Creation of Europe’s snake arrangement
 One of the best known pegged exchange rate system established by several
European countries in April 1972 to align their currencies.
 This arrangement is known as the snake.
4. Pegged Exchange rate system.

 Snake was difficult to maintain.

 Because market pressures caused some currencies to move outside their
established limits.
 Creation of the European Monitory system.
 It was pushed into operation in March 1979.
 The EMS was similar to the snake but the specific characteristics differed.
 Under EMS, the exchange rate of member countries were held together
within specific limits and were also tied to the ECU.
 Its value was a weighted average of the exchange rates of the member
countries and each weight was determined by a member’s relative GNP
product and activity in Intra- European trade.
 Currencies were allowed to fluctuate by no more than 2.25% (6% for some
currencies) from the initially established Par value. What is ERM?????
4. Pegged Exchange rate system.

 Demise of the Pegged Exchange rate system.

 In 1992, the exchange rate mechanism experienced severe problems as
economic conditions and goals vary among European countries.
 The German government was more concerned about inflation because its
economy was relatively strong.
 It increased local interest rates to prevent excessive spending and inflation.
 while other European countries were concerned to stimulate their economy
to lower their unemployment levels.
 So, they wanted to reduce their interest rates.
 In 1992, the British and Italian governments suspended their participation.
 This provided momentum for single European currency (Euro) in 1992.
 How Mexico’s Pegged system led to Mexican Peso crises (Book).
Currency Boards
 Currency Board is a system for Pegging the value of the local currency to
some other specified currency.
 The board must maintain currency reserves for all the currency that it has
printed.
 A currency Board can stabilize a currency’s value that is mandatory
because investors generally avoid investing in a country if they expect the
local currency will weaken substantially.
 However, the currency board is worth considering only if the governments
can convince investors that the exchange rate will be maintained.
 For example, the Hong Kong has tied the value of the Hong Kong dollar to
the US dollar (HK $7.80 = 1 US$)
 Every Hong Kong dollar is backed by a US dollar in Reserves.
 El Salvador set its currency (the colon) to be valued at 8.75 US dollar.
Currency Boards

 Is currency board effective????

 It is effective only if investors believe that it will last.
 If investors expect that market forces will prevent a government
from maintaining the local currency’s exchange rate, then…..
 They will attempt to move their funds to other countries where they
expect the local currency to be stronger.
 What happens when foreign investors withdraw funds?????
 When they withdraw funds and convert the funds into different
currency, they place downward pressure on the local currency.
 If the supply of the currency continued to exceed the demand, the
government will be forced to devalue its currency.
Currency Boards
 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. Why?????
 Because its rates must be aligned with the interest rates of the currency to
which it is tied.
 For example, If the US raises its interest rates, Hong Kong would be forced
to raise its interest rates (on securities with similar risk as those in the
United states.
 Otherwise, investors in Hong Kong could invest their money in the United
States and earn a higher rate.
Dollarization

 It is the replacement of the foreign currency with US dollars.

 How different from Currency Board????
 It is the step beyond currency board.
 It forces the local currency to be replaced by the dollars.
 Currency board and dollarization both attempt to peg the local currency
value.
 For example 1990-2000, Ecuador's currency caused unfavorable and
unstable trade conditions, high inflations and volatile economic conditions.
 They replaced the Sucre with US dollar as its currency.
 Inflation declined and economic growth has increased.
 Dollarization had a favorable effect.
Government intervention
 Central bank may intervene to control the currency’s value.
 For example in USA Federal reserve system.
 In Pakistan SBP.
 In India the Bank of India.
 In Japan the Bank of Japan.
 In Netherlands the Douche Bank.
 In Scotland the Royal Bank of Scotland.
 Bank of Hong Kong.
 Bank of China.
 Bank of England.
 They attempt to control the growth of money supply which has a healthy
effect.
Reasons for government intervention.
 The degree to which the home currency’s is controlled varies among central banks.
 Central banks manage exchange rate for three reasons.
 1. To smooth exchange rate movements.
 It’s action is to keep business cycle less volatile.
 The central banks may encourage the international trade by reducing exchange rate
uncertainty.
 Smoothing exchange rates may reduce fears in the financial markets.
 2. establish implicit (unofficial) exchange rate boundaries.
 Some central banks maintain unofficial boundaries.
 Analysts anticipate (or forecast) that the currency’s value will not fall below or rise
above the benchmark value.
 Respond to temporary disturbances ( for example rise of Petrol price in Japan)
 Anticipators will change yens for dollars and yen value will depreciate.
Direct intervention
 To force the dollar to depreciate……
 The FED exchange the dollars which it holds as reserves for other foreign
currencies in the foreign exchange market
 By “ flooding the dollars in the foreign exchange market, the FED puts a
downward pressure on the value of the dollars.
 If FED wants to strengthen the then……….
 It exchange other currencies for the dollars in the open market.
 What is open market???????
 For example, during early 2004, the Bank of Japan to weaken the yen
exchanged yens for $ 100 B. Again…….
 March 5, 2004 it exchange yens for $ 20 B to lower the value of yen.
 Note… Direct intervention only effective when coordinated efforts among
Central Banks to strengthen or weaken a particular currency.
Direct intervention
 Reliance on Reserves.
 Potential effectiveness of Intervention is the amount of reserves.
 If the Central Bank has low level of reserves then it will not be able to
exert pressure on the markets.
 If the Central Bank has high level of reserves then it will be able to exert
pressure on the markets.
 The volume of foreign exchange transactions on a single day now
exceeds the combined value of reserves of all the central banks.
 Number of direct intervention has now decreased.
 In 1989, the FED intervened on 97 different days. Since then the FED
has not intervened on more than 20 days in a year.
Direct intervention
 Non- sterilized Intervention.
 When the FED intervenes in the foreign exchange market without adjusting
for the change in the money supply….. Then
 It is said that central bank is taking the sterilized intervention.
 For example if the FED exchanges dollars for other currencies.
 It means that it wants to depreciate the value of the dollar or to strengthen
the foreign currencies.
 The dollar money supply increases.
 Sterilized intervention.
 In this kind of intervention, the FED intervenes in the foreign exchange
market and at the same time…..
 Engages offsetting transactions in the treasury securities market.
 The dollar money supply is unchanged.
Direct intervention
 Sterilized intervention.
 For example, if the Fed wants to weaken the dollar, without effecting the money
supply then…….
 1. it exchanges dollars for other currencies….
 2. sells some of its holdings of treasury securities for dollars.
 What is the net effect of this action???????????
 Increase in the investor’s holdings of treasury securities and…..
 A decrease in bank foreign currency balances.
 Speculating on direct intervention.
 Some speculators attempt to determine when FED intervention is occurring.
 Normally FED intervenes without being noticed.
 FED may pretend to be interested in selling dollars when it is actually buying the
dollars.
 It calls commercial banks and obtains both bid and ask quotes (rates) on currencies.
Indirect Intervention

 e = f ( chg INF, chg INT, chg INC, chg GC, chg EXPECTATIONS)
 Where e = spot rate of currency.

 Government Adjustment of Interest rates (FDI)

 Government use of foreign exchange control.