Chapter 6

Government Influence
on Exchange Rates
 Exchange Rate Systems

• Fixed
• Freely floating
• Managed float
• 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 boundaries.
• In general, the central bank must offset any
imbalance between demand and supply conditions
for its currency in order to prevent its value from
changing.
• The central bank may devalue (reduce the value of)
or revalue (increase the value of) the currency.
 Fixed Exchange Rate System

• Bretton Woods Agreement, 1944–1971

• Smithsonian Agreement, 1971–1973
• Advantages of fixed exchange rates
• Disadvantages of fixed exchange rates
 Freely Floating
Exchange Rate System

• In a freely floating exchange rate system, exchange

rate values are determined by market forces without
intervention by governments.
• A freely floating exchange rate adjusts on a continual
basis in response to the demand and supply
conditions for that currency.
• Advantages of a freely floating system
• Disadvantages of a freely floating system
 Managed Float
Exchange Rate System

• Exchange rates are allowed to fluctuate on a daily

basis and there are no official boundaries.
• Governments can and sometimes do intervene to
prevent their currencies from moving too far in a
certain direction.
• Criticisms of the managed float system
 Pegged Exchange Rate
System
• The home currency’s value is pegged to one foreign
currency or to an index of currencies.
• Although the home currency’s value is fixed in terms
of the foreign currency to which it is pegged, it
moves in line with that currency against other
currencies.
• Limitations of a pegged exchange rate
• Currency boards used to peg currency values
• Interest rates of pegged currencies
• Exchange rate risk of a pegged currency
 Dollarization

• Replacement of a foreign currency with U.S. dollars

• The decision to use U.S. dollars as the local currency
cannot be easily reversed because in that case the
country no longer has a local currency.
 A Single European Currency

• Monetary policy in the Eurozone

• Impact on firms in the Eurozone
• Impact on financial flows in the Eurozone
• Exposure of countries within the Eurozone
• Impact of crises within the Eurozone
• Impact on a country that abandons the euro
• Impact of abandoning the euro on Eurozone
conditions
 Government Intervention

• Reasons for government intervention:

– To smooth exchange rate movements
– To establish implicit exchange rate boundaries
– To respond to temporary disturbances
 Government Intervention

• Direct intervention: the central bank can purchase or

sell currencies in the foreign exchange market,
thereby altering demand and supply conditions and
hence the currencies’ equilibrium values.
• The potential effectiveness of a central bank’s direct
intervention is influenced by the amount of reserves
it can use.
Government Intervention
 Government Intervention

• Nonsterilized intervention: the central bank

intervenes in the foreign exchange market without
adjusting for the change in the money supply.
• Sterilized intervention: the central bank intervenes in
the foreign exchange market and simultaneously
engages in offsetting transactions in the government
securities markets.
Government Intervention
 Government Intervention

• Indirect intervention: the central bank can influence

the economic factors that affect equilibrium
exchange rates.
• Government control of interest rates
• Government use of foreign exchange controls
• Intervention warnings
 Intervention as a Policy Tool

• Influence of a weak home currency:

 Intervention as a Policy Tool

• Influence of a strong home currency: