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International Financial Management 11th Edition

by Jeff Madura

Part 2 Exchange Rate Behavior

Exchange Rate Systems

Exchange rate systems can be classified according to the degree of government control and fall into the following categories:  Fixed  Freely floating  Managed float  Pegged

Fixed Exchange Rate System

1. Exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries.

2. Central bank can reset a fixed exchange rate by devaluing or reducing the value of the currency against other currencies.

3. Central bank can also revalue or increase the value of its currency against other currencies.

Fixed Exchange Rate System

 Examples:  Bretton Woods Agreement 1944 – 1971 – Each currency was

valued in terms of gold.  Smithsonian Agreement 1971 – 1973 – called for a

devaluation of the U.S. dollar by about 8 percent against other currencies.

 Advantages of fixed exchange rate system  Insulate country from risk of currency appreciation.  Allow firms to engage in direct foreign investment without

currency risk.  Disadvantages of fixed exchange rate system

 Risk that government will alter value of currency.  Country and MNC may be more vulnerable to economic

conditions in other countries.

Freely Floating Exchange Rate System

 Exchange rates are determined by market forces without government intervention.

 Advantages of freely floating system:  Country is more insulated from inflation of other countries.  Country is more insulated from unemployment of other

countries.  Does not require central bank to maintain exchange rates

within specified boundaries.

 Disadvantages of freely floating system:  Can adversely affect a country that has high unemployment.  Can adversely affect a country with high inflation.

Managed Float Exchange Rate System

 Governments sometimes intervene to prevent their currencies from moving too far in a certain direction.

 Critics suggest that managed float allows a government to manipulate exchange rates to benefit its own country at the expense of others.

 Currencies of most large developed countries are allowed to float, although they may be periodically managed by their respective central banks.

Exhibit 6.1 Exchange Rate Arrangements

Pegged Exchange Rate System

 Home currency value is pegged to one foreign currency or to an index of currencies.

 May attract foreign investment because exchange rate is expected to remain stable.

 Weak economic or political conditions can cause firms and investors to question whether the peg will be broken.

Pegged Exchange Rate Systems (Cont.)

 Currency Boards Used to Peg Currency Values – 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.

 Interest Rates of Pegged Currencies – Interest rate will move in tandem with the interest rate of the currency to which it is tied.

 Exchange Rate Risk of a Pegged Currency – (Exhibit 6.2) provides examples of countries that have pegged the exchange rate of their currency to a specific currency. Currencies are commonly pegged to the U.S. dollar or to the euro.

Exhibit 6.2 Pegged Exchange Rates

Dollarization

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

 This process is a step beyond a currency board because it forces the local currency to be replaced by the U.S. dollar. Although dollarization and a currency board both attempt to peg the local currency’s value, the currency board does not replace the local currency with dollars.

A Single European Currency

 Monetary Policy in the Eurozone  European Central Bank – based in Frankfurt and is responsible for

setting monetary policy for all participating European countries  Objective is to control inflation in the participating countries and to

stabilize (within reasonable boundaries) the value of the euro with respect to other major currencies.

 Impact on Firms in the Eurozone – Prices of products are now more comparable among European countries.

 Impact on Financial Flows in the Eurozone – Bond investors who reside in the eurozone can now invest in bonds issued by governments and corporations in these countries without concern about exchange rate risk, as long as the bonds are denominated in euros.

A Single European Currency

 Exposure of Countries within the Eurozone  A single European monetary policy prevents any individual

European country from solving local economic problems with its own unique monetary policy.

 Any given monetary policy used in the eurozone during a particular period may enhance conditions in some countries and adversely affect others.

 Impact of Crises within the Eurozone – may affect the economic conditions of the other participating countries because they all rely on the same currency and same monetary policy.

Reasons for Government Intervention

1. Smooth exchange rate movements If a central bank is concerned that its economy will be affected by abrupt movements in its home currency’s value, it may attempt to smooth the currency movements over time.

2. Establish implicit exchange rate boundaries Some central banks attempt to maintain their home currency rates within some unofficial, or implicit, boundaries.

3. Respond to temporary disturbances A central bank may intervene to insulate a currency’s value from a temporary disturbance.

Direct Intervention

To force the dollar to depreciate, the Fed can intervene directly by exchanging dollars that it holds as reserves for other foreign currencies in the foreign exchange market. By “flooding the market with dollars” in this manner, the Fed puts downward pressure on the dollar. If the Fed desires to strengthen the dollar, it can exchange foreign currencies for dollars in the foreign exchange market, thereby putting upward pressure on the dollar.

Direct Intervention

 Reliance on reserves The potential effectiveness of a central bank’s direct intervention is the amount of reserves it can use.

 Nonsterilized versus sterilized intervention (See Exhibit 6.4)  When the Fed intervenes in the foreign exchange market without

adjusting for the change in the money supply, it is engaging in a nonsterilized intervention.

 In a sterilized intervention, the Fed intervenes in the foreign exchange market and simultaneously engages in offsetting transactions in the Treasury securities markets.

 Speculating on direct intervention Some traders in the foreign exchange market attempt to determine when Federal Reserve intervention is occurring and the extent of the intervention in order to capitalize on the anticipated results of the intervention effort.

Exhibit 6.4 Forms of Central Bank Intervention in the Foreign Exchange Market

Indirect Intervention

Government Control of Interest Rates by increasing or reducing interest rates Foreign Exchange Controls such as restrictions on the exchange of the currency Intervention Warnings intended to warn speculators. The announcements could discourage additional speculation and might even encourage some speculators to unwind (liquidate) their existing positions in the currency.

Intervention as a Policy Tool

1. A weak home currency can stimulate foreign demand for products. (See Exhibit 6.5)

2. A strong home currency can encourage consumers and corporations of that country to buy goods from other countries. (See Exhibit 6.6)

Exhibit 6.5 How Central Bank Intervention Can Stimulate the U.S. Economy

Exhibit 6.6 How Central Bank Intervention Can Reduce Inflation

SUMMARY

 Exchange rate systems can be classified as fixed rate, freely floating, managed float, and pegged. In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries. In a freely floating exchange rate system, exchange rate values are determined by market forces without intervention. In a managed float system, exchange rates are not restricted by boundaries but are subject to government intervention. In a pegged exchange rate system, a currency’s value is pegged to a foreign currency or a unit of account and moves in line with that currency (or unit of account) against other currencies.

SUMMARY (Cont.)

 Numerous European countries use the euro as their home currency. The single currency allows international trade by firms within the eurozone without foreign exchange expenses and without concerns about future exchange rate movements. However, countries that participate in the euro do not have complete control of their monetary policy because one monetary policy is applied to all countries in the eurozone. In addition, some countries might be more susceptible to a crisis in another country in the eurozone as a result of being in the eurozone.

SUMMARY (Cont.)

 Governments can use direct intervention by purchasing or selling currencies in the foreign exchange market, thereby affecting demand and supply conditions and, in turn, affecting the equilibrium values of the currencies. When a government purchases a currency in the foreign exchange market, it puts upward pressure on the currency’s equilibrium value. When a government sells a currency in the foreign exchange market, it puts downward pressure on the currency’s equilibrium value. Governments can use indirect intervention by influencing the economic factors that affect equilibrium exchange rates.

SUMMARY (Cont.)

 When government intervention is used to weaken the U.S. dollar, the weak dollar can stimulate the U.S. economy by reducing the U.S. demand for imports and increasing the foreign demand for U.S. exports. Thus, the weak dollar tends to reduce U.S. unemployment, but it can increase U.S. inflation. When government intervention is used to strengthen the U.S. dollar, the strong dollar can increase the U.S. demand for imports, thereby intensifying foreign competition. The strong dollar can reduce U.S. inflation but may cause a higher level of U.S. unemployment.

Slide Number 1
Part 2 Exchange Rate Behavior
Exchange Rate Systems
Fixed Exchange Rate System
Fixed Exchange Rate System
Freely Floating Exchange Rate System
Managed Float Exchange Rate System
Exhibit 6.1 Exchange Rate Arrangements
Pegged Exchange Rate System
Pegged Exchange Rate Systems (Cont.)
Exhibit 6.2 Pegged Exchange Rates
Dollarization
A Single European Currency
A Single European Currency
Reasons for Government Intervention
Direct Intervention
Direct Intervention
Exhibit 6.4 Forms of Central Bank Intervention in the Foreign Exchange Market
Indirect Intervention
Intervention as a Policy Tool
Exhibit 6.5 How Central Bank Intervention Can Stimulate the U.S. Economy
Exhibit 6.6 How Central Bank Intervention Can Reduce Inflation
SUMMARY
SUMMARY (Cont.)
SUMMARY (Cont.)
SUMMARY (Cont.)