Part II Exchange Rate Behavior

Existing spot
locational
arbitrage exchange rates
Existing spot at other locations
exchange rate
triangular Existing cross
arbitrage exchange rates
covered interest arbitrage of currencies

Existing forward Existing inflation

exchange rate rate differential
Fisher
effect
covered interest arbitrage purchasing power parity

international
Existing interest Fisher effect Future exchange
rate differential rate movements
Chapter
6
Government Influence
On Exchange Rates
 Chapter Objectives

• To describe the exchange rate systems

used by various governments;
• To explain how governments can use
direct and indirect intervention to
influence exchange rates; and
• To explain how government intervention in
the foreign exchange market can affect
economic conditions.
 Exchange Rate Systems

• Exchange rate systems can be classified

according to the degree to which the rates
are controlled by the government.
• Exchange rate systems normally fall into one
of the following categories:
¤ fixed ( 固定匯率 )
¤ freely floating ( 純浮動匯率 )
¤ managed float ( 管理浮動匯率 )
¤ 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.
• The Bretton Woods era (1944-1971) fixed
each currency’s value in terms of gold. ( 布芮
頓伍茲固定匯率 )
• The 1971 Smithsonian Agreement ( 斯密森協
定 ) which followed merely adjusted the
exchange rates and expanded the
fluctuation boundaries. The system was still
fixed.
 Fixed Exchange Rate System

• Pros: Work becomes easier for the MNCs.

• Cons: Governments may revalue their
currencies. In fact, the dollar was
devalued more than once after the U.S.
experienced balance of trade deficits.
• Cons: Each country may become more
vulnerable to the economic conditions in
other countries.
Example: Fixed Exchange Rate System
Two countries: US, UK
If US experiences a higher inflation rate than UK, US
consumers will buy more goods from UK and UK
will reduce their imports of US goods (due to high
US prices).
This reaction will force US production down and
unemployment up.
It also causes higher inflation in UK due to the
excessive demand for UK goods.
The high inflation in US can cause high inflation in
UK.
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.
Freely Floating Exchange Rate System

• 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.
Example: floating exchange rate system
A country is more insulated from the inflation of
other countries.

If US experiences a high rate of inflation, the

increased US demand for UK goods will place
upward pressure on the value of British pound.
The reduced UK demand for US goods will result in
a reduced supply of pounds for sale (exchanged
for dollars), which will place upward pressure on
the British pound’s value.
Continued.
The pound will appreciate.
(it was not allowed to appreciate under fixed rate
system).
This appreciation will make UK goods more
expensive for US consumers.
In UK, the actual price of the goods as measured in
British pounds may be unchanged.
Even though US prices have increased, UK
consumers will continue to buy US goods
because they can exchange their pounds for
more US dollars.
Example: floating exchange rate system
A country is more insulated from unemployment
problems of other countries.

The decline in US purchases of UK goods will reflect a

reduced US demand for British pounds.
The reduced demand can cause the pound to depreciate
against the dollar.
(under the fixed rate system, the pound would not be
allowed to depreciate).
The depreciation of the pound will make UK goods
cheaper to US consumers, offsetting the reduction in
demand for these goods resulting from a lower level
of US income.
Freely Floating Exchange Rate System

• Cons: MNCs may need to devote

substantial resources to managing their
exposure to exchange rate fluctuations.
• Cons: The country that initially
experienced economic problems (such as
high inflation, increasing unemployment
rate) may have its problems compounded.
Example: floating exchange rate
If US experiences high inflation, the dollar may
weaken.
A weaker US dollar causes import prices to be
higher. This can increase the price of US
materials, which will in turn increase US prices of
finished goods.
Higher foreign prices can force US consumers to
purchase domestic goods.
As US producers recognize their foreign
competition has been reduced due to the weaker
dollar, they can raise their prices without losing
their customers to foreign competition.
Example: floating exchange rate
If US unemployment rate is rising, US
demand for imports will decrease, putting
upward pressure on the value of the
dollar.
A stronger dollar will cause US consumers
to buy foreign goods rather than US goods
because the foreign goods can be
purchased cheaply.
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 rates from
moving too much in a certain direction.
• Cons: A government may manipulate its
exchange rates such that its own country
benefits at the expense 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 some unit of account, and
moves in line with that currency or unit
against other currencies.
• The European Economic Community’s
snake arrangement (1972-1979) pegged the
currencies of member countries within
established limits of each other.
 Pegged Exchange Rate System
• The European Monetary System ( 歐洲貨幣制
度 )which followed in 1979 held the
exchange rates of member countries
together within specified limits and also
pegged them to a European Currency Unit
(ECU 歐洲通貨單位 ) through the exchange
rate mechanism (ERM 匯率機制 ).
¤ The ERM experienced severe problems in
1992, as economic conditions and goals
varied among member countries.
 Pegged Exchange Rate System

• In 1994, Mexico’s central bank pegged the

peso to the U.S. dollar, but allowed a band
within which the 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 allowed the peso to float freely.
The Mexican peso crisis had just began ...
 Currency Boards

• A currency board ( 外匯局 ) is a system for

maintaining the value of the local currency
with respect to some other 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 1991.
 Currency Boards

• For a currency board to be successful, it

must have credibility in its promise to
maintain the exchange rate.
• It has to intervene to defend its position
against the pressures exerted by economic
conditions, as well as by speculators who
are betting that the board will not be able to
support the specified exchange rate.
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 the 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.
Example:
If HK lowers its interest rates to stimulate its
economy, its interest rate would be lower than US
interest rates.
Investors based on HK would be enticed to
exchange rate HK dollars for US dollars because
US interest rates are higher.
Since HK dollar is tied to US dollar, the investors
can exchange the proceeds of their investment
back to HK dollars at the end of investment
period without concern about exchange rate risk
because the exchange rate is fixed.
Continued.
If US raises its interest rates, HK would be
forced to raise its interest rates.
Otherwise, investors in HK can invest their
money in US and earn a higher rate.
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 the 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 2000.
 A Single European Currency €
• In 1991, the Maastricht treaty called for a
single European currency. On Jan 1, 1999,
the euro was adopted by Austria, Belgium,
Finland, France, Germany, Ireland, Italy,
Luxembourg, Netherlands, Portugal, and
Spain. Greece joined the system in 2001.
• By 2002, the national currencies of the 12
participating countries will be withdrawn
and completely replaced with the euro.
 A Single European Currency €
• Within the euro-zone, cross-border trade
and capital flows will occur without the
need to convert to another currency.
• European monetary policy is also
consolidated because of the single money
supply. The Frankfurt-based European
Central Bank (ECB 歐洲中央銀行 ) is
responsible for setting the common
monetary policy.
 A Single European Currency €
• The ECB aims to control inflation in the
participating countries and to stabilize the
euro within reasonable boundaries.
• The common monetary policy may eventually
lead to more political harmony.
• Note that each participating country may have
to rely on its own fiscal policy (tax and
government expenditure decisions) to help
solve local economic problems.
 A Single European Currency €
• As currency movements among the
European countries will be eliminated,
there should be an increase in all types of
business arrangements, more comparable
product pricing, and more trade flows.
• It will also be easier to compare and
conduct valuations of firms across the
participating European countries.
 A Single European Currency €
• Stock and bond prices will also be more
comparable and there should be more
cross-border investing. However, non-
European investors may not achieve as
much diversification as in the past.
• Exchange rate risk and foreign exchange
transaction costs within the euro-zone will
be eliminated, while interest rates will have
to be similar.
 A Single European Currency €
• Since its introduction in 1999, the euro has
declined against many currencies.
• This weakness was partially attributed to
capital outflows from Europe, which was in
turn partially attributed to a lack of confidence
in the euro.
• Some countries had ignored restraint in favor
of resolving domestic problems, resulting in a
lack of solidarity.
A Single European Currency
 strengthens € weakens 
€
1.80

1.60 €/£
1.40

1.20

1.00 €/$
0.80 €/100¥
0.60
€/SwF (Swiss Franc)
0.40
Jan-99 Jul-99 Jan-00 Jul-00 Jan-01 Jul-01
 Government Intervention

• Each country has a government agency

(called the central bank) that may
intervene in the foreign exchange market
to control the value of the country’s
currency.
• In the United States, the Federal
Reserve System (Fed) is the
central bank.
 Government Intervention

• 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 more volatile in the
absence of intervention.
 Government Intervention

• Direct intervention refers to the exchange

of currencies that the central bank holds
as reserves for other currencies in the
foreign exchange market.
• Direct intervention is usually most
effective when there is a coordinated
effort among central banks.
 Government Intervention

Fed exchanges $ for £ Fed exchanges £ for $

to strengthen the £ to weaken the £
Value Value S1
of £ S1 of £ S2
V2 V1
V1
D2 V2
D1 D1

Quantity of £ Quantity of £
 Government Intervention

• When a central bank intervenes in the

foreign exchange market without adjusting
for the change in money 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.
 Nonsterilized Intervention
Federal Reserve
To $ C$
Strengthen
the C$: Banks participating
in the foreign
exchange market

Federal Reserve
To Weaken $ C$
the C$:
Banks participating
in the foreign
exchange market
 Sterilized Intervention
Federal Reserve T- securities
To $ C$ Financial
Strengthen $ institutions
the C$: Banks participating that invest
in the foreign in Treasury
exchange market securities

$
Federal Reserve
To Weaken $ C$ Financial
T- securities
the C$: institutions
Banks participating that invest
in the foreign in Treasury
exchange market securities
 Government Intervention

• Some speculators attempt to determine

when the central bank is intervening, and
the extent of the intervention, in order to
capitalize on the anticipated results of the
intervention effort.
 Government Intervention

• Central banks can also engage in indirect

intervention by influencing the factors that
determine the value of a currency.
• For example, the Fed may attempt to
increase interest rates (and hence boost the
dollar’s value) by reducing the U.S. money
supply.
¤ Note that high interest rates adversely affects
local borrowers.
 Government Intervention

• Governments may also use foreign

exchange controls (such as restrictions
on currency exchange) as a form of
indirect intervention.
Exchange Rate Target Zones

• Many economists have criticized the present

exchange rate system because of the wide
swings in the exchange rates of major
currencies.
• Some have suggested that target zones be
used, whereby an initial exchange rate will
be established with specific boundaries (that
are wider than the bands used in fixed
exchange rate systems).
Exchange Rate Target Zones

• The ideal target zone should allow rates to

adjust to economic factors without
causing wide swings in international trade
and fear in the financial markets.
• However, the actual result may be a
system no different from what exists
today.
 Intervention as a Policy Tool

• Like tax laws and money supply, the

exchange rate is a tool which a
government can use to achieve its desired
economic objectives.
• A weak home currency can stimulate
foreign demand for products, and hence
local jobs. However, it may also lead to
higher inflation.
 Intervention as a Policy Tool

• A strong currency may cure high inflation,

since the intensified foreign competition
should cause domestic producers to
refrain from increasing prices. However, it
may also lead to higher unemployment.
Impact of Government Actions on Exchange Rates

Government Monetary
and Fiscal Policies

Relative Interest Relative Inflation Relative National

Rates Rates Income Levels

International Exchange Rates International

Capital Flows Trade
Government
Purchases & Sales
of Currencies

Government Intervention in
Tax Laws, Foreign Exchange Market Quotas,
etc. Tariffs, etc.
Impact of Central Bank Intervention
on an MNC’s Value
Direct Intervention
Indirect Intervention

m 
n 

E CFj , t  E ER j , t  
 j 1 
Value =   
t =1  1  k  t

 
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
 Chapter Review

• Exchange Rate Systems

¤ Fixed Exchange Rate System
¤ Freely Floating Exchange Rate System
¤ Managed Float Exchange Rate System
¤ Pegged Exchange Rate System
¤ Currency Boards
¤ Exposure of a Pegged Currency to Interest
Rate and Exchange Rate Movements
¤ Dollarization
 Chapter Review
• A Single European Currency
¤ Membership
¤ Euro Transactions
¤ Impact on European Monetary Policy
¤ Impact on Business Within Europe
¤ Impact on the Valuation of Businesses in
Europe
¤ Impact on Financial Flows
¤ Impact on Exchange Rate Risk
¤ Status Report on the Euro
 Chapter Review

• Government Intervention
¤ Reasons for Government Intervention
¤ Direct Intervention
¤ Indirect Intervention
• Exchange Rate Target Zones
 Chapter Review

• Intervention as a Policy Tool

¤ Influence of a Weak Home Currency on the
Economy
¤ Influence of a Strong Home Currency on
the Economy
• How Central Bank Intervention Can Affect
an MNC’s Value