international financial management chapter 6 - government influence on exchang rate

7/21/2019 international financial management chapter 6 - government influence on exchang rate

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Part II Exchange Rate Behavior

Existing spot

exchange ratesat other locations

Existing crossexchange ratesof currencies

Existing inflationrate differential

Future exchange

rate movements

Existing spotexchange rate

Existing forwardexchange rate

Existing interest

rate differential

locationalarbitrage

triangulararbitrage

purchasing power parity

internationalFisher effect

covered interest arbitrage

covered interest arbitrage

Fisher

effec

t


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Government InfluenceOn Exchange Rates

!hapter

South-Western/Thomson Learning 2003


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!hapter Ob"ectives

#o describe the exchange ratesystems used by various governments$

#o explain how governments can usedirect and indirect intervention to

influence exchange rates$ and

#o explain how government intervention inthe foreign exchange mar%et can affect

economic conditions&


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Exchange Rate 'ystems

Exchange rate systems can be classifiedaccording to the degree to which the rates

are controlled by the government& Exchange rate systems normally fall into one

of the following categories( fixed freely floating managed float pegged


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In a fixed exchange rate system) exchangerates are either held constant or allowed to

fluctuate only within very narrow bands& #he Bretton *oods era +,-../,-0,1 fixed each

currency2s value in terms of gold&

#he ,-0, 'mithsonian 3greement whichfollowed merely ad"usted the exchange rates

and expanded the fluctuation boundaries& #he

system was still fixed&

Fixed

Exchange Rate 'ystem


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Find out more about the Bretton *oodsconference and the 'mithsonian

3greement at( http://www.imfsite.org/origins/confer.html

http://www.mises.org/money.asp

Online 3pplication
http://www.imfsite.org/origins/confer.htmlhttp://www.mises.org/money.asphttp://www.mises.org/money.asphttp://www.mises.org/money.asphttp://www.mises.org/money.asphttp://www.imfsite.org/origins/confer.htmlhttp://www.imfsite.org/origins/confer.htmlhttp://www.imfsite.org/origins/confer.html


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Pros:*or% becomes easier for the 45!s&

Cons:Governments may revalue their

currencies& In fact) the dollar wasdevalued more than once after the 6&'&

experienced balance of trade deficits&

Cons:Each country may become morevulnerable to the economic conditions in

other countries&

Fixed



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In a freely floating exchange rate system)exchange rates are determined solely by

mar%et forces& Pros:Each country may become more

insulated against the economic problems in

other countries&

Pros:!entral ban% interventions that mayaffect the economy unfavorably are no longer

needed&

Freely Floating



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Pros:Governments are not restricted byexchange rate boundaries when setting

new policies& Pros:7ess capital flow restrictions are

needed) thus enhancing the efficiency of

the financial mar%et&

Freely Floating



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Cons:45!s may need to devotesubstantial resources to managing their

exposure to exchange rate fluctuations& Cons:#he country that initially

experienced economic problems +such as

high inflation) increasing unemploymentrate1 may have its problems compounded&

Freely Floating



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In a managed +or 8dirty91 floatexchange ratesystem) exchange rates are allowed to move

freely on a daily basis and no officialboundaries exist& :owever) governments

may intervene to prevent the rates from

moving too much in a certain direction&

Cons:3 government may manipulate itsexchange rates such that its own country

benefits at the expense of others&

4anaged Float



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In apegged exchange rate system) thehome currency2s 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&

#he European Economic !ommunity2ssnakearrangement +,-0;/,-0-1 pegged thecurrencies of member countries within

established limits of each other&

Pegged



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#he European 4onetary 'ystem whichfollowed in ,-0- held the exchange rates of

member countries together within specifiedlimits and also pegged them to a European

!urrency 6nit +E!61 through the exchange

rate mechanism +ER41&

The ERM experienced severe problems in!!"# as economic conditions and goals

varied among member co$ntries.

Pegged



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In ,--.) 4exico2s central ban% pegged thepeso to the 6&'& dollar) but allowed a band

within which the peso2s value couldfluctuate against the dollar&

%y the end of the year# there was s$bstantial

downward press$re on the peso# and the

central ban& allowed the peso to float freely.The Mexican peso crisis had '$st began ...

Pegged



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For more information on the 4exican pesocrisis) visit(

http://www.cfr.org/p$blic/p$bs/mexican.html http://www.frbatlanta.org/p$blica

/E()*RE+/RE+,-%/'anfeb!.html

http://www.broo&.ed$/views/papers/l$stig/0.htm

Online 3pplication
http://www.cfr.org/public/pubs/mexican.htmlhttp://www.frbatlanta.org/publica/ECO-REV/REV_ABS/janfeb96.htmlhttp://www.frbatlanta.org/publica/ECO-REV/REV_ABS/janfeb96.htmlhttp://www.brook.edu/views/papers/lustig/114.htmhttp://www.brook.edu/views/papers/lustig/114.htmhttp://www.brook.edu/views/papers/lustig/114.htmhttp://www.brook.edu/views/papers/lustig/114.htmhttp://www.brook.edu/views/papers/lustig/114.htmhttp://www.brook.edu/views/papers/lustig/114.htmhttp://www.brook.edu/views/papers/lustig/114.htmhttp://www.brook.edu/views/papers/lustig/114.htmhttp://www.frbatlanta.org/publica/ECO-REV/REV_ABS/janfeb96.htmlhttp://www.frbatlanta.org/publica/ECO-REV/REV_ABS/janfeb96.htmlhttp://www.frbatlanta.org/publica/ECO-REV/REV_ABS/janfeb96.htmlhttp://www.frbatlanta.org/publica/ECO-REV/REV_ABS/janfeb96.htmlhttp://www.frbatlanta.org/publica/ECO-REV/REV_ABS/janfeb96.htmlhttp://www.cfr.org/public/pubs/mexican.htmlhttp://www.cfr.org/public/pubs/mexican.htmlhttp://www.cfr.org/public/pubs/mexican.htmlhttp://www.cfr.org/public/pubs/mexican.htmlhttp://www.cfr.org/public/pubs/mexican.html


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!urrency Boards

3 currency board is a system formaintaining the value of the local currency

with respect to some other specifiedcurrency&

For example) :ong


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!urrency Boards

For a currency board to be successful) itmust 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&


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Find out more about :ong


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Exposure of a Pegged !urrency to

Interest Rate 4ovements 3 country that uses a currency board does

not have complete control over its local

interest rates) as the rates must be alignedwith the interest rates of the currency to

which the local currency is tied&

5ote that the two interest rates may not be

exactly the same because of different

ris%s&


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3 currency that is pegged to anothercurrency will have to move in tandem with

that currency against all other currencies& 'o) the value of a pegged currency does

not necessarily reflect the demand and

supply conditions in the foreign exchange

mar%et) and may result in uneven trade or

capital flows&

Exposure of a Pegged !urrency to

Exchange Rate 4ovements


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Aollariation

Dollarizationrefers to the replacement of alocal currency with 6&'& dollars&

Aollariation goes beyond a currencyboard) as the country no longer has a local

currency&

For example) Ecuador implementeddollariation in ;CCC&


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3 table showing the currencies of theworld and their exchange rate

arrangements can be found at( http://pacific.commerce.$bc.ca/xr

/c$rrency,table.html

Online 3pplication
http://pacific.commerce.ubc.ca/xr/currency_table.htmlhttp://pacific.commerce.ubc.ca/xr/currency_table.htmlhttp://pacific.commerce.ubc.ca/xr/currency_table.htmlhttp://pacific.commerce.ubc.ca/xr/currency_table.htmlhttp://pacific.commerce.ubc.ca/xr/currency_table.htmlhttp://pacific.commerce.ubc.ca/xr/currency_table.htmlhttp://pacific.commerce.ubc.ca/xr/currency_table.html


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13 'ingle European !urrency

In ,--,) the 4aastricht treaty called for asingle European currency& On Dan ,) ,---)

the euro was adopted by 3ustria) Belgium)Finland) France) Germany) Ireland) Italy)

7uxembourg) 5etherlands) Portugal) and

'pain& Greece "oined the system in ;CC,&

By ;CC;) the national currencies of the ,;participating countries will be withdrawn

and completely replaced with the euro&


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*ithin the euro/one) cross/border tradeand capital flows will occur without the

need to convert to another currency& European monetary policy is also

consolidated because of the single money

supply& #he Fran%furt/based European

!entral Ban% +E!B1 is responsible for

setting the common monetary policy&



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#he E!B aims to control inflation in theparticipating countries and to stabilie the

euro within reasonable boundaries& #he common monetary policy may eventually

lead to more political harmony&

5ote that each participating country mayhave to rely on its own fiscal policy +tax and

government expenditure decisions1 to help

solve local economic problems&



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3s currency movements among theEuropean countries will be eliminated)

there should be an increase in all types ofbusiness arrangements) more comparable

product pricing) and more trade flows&

It will also be easier to compare andconduct valuations of firms across the

participating European countries&



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'toc% and bond prices will also be morecomparable and there should be more

cross/border investing& :owever) non/European investors may not achieve as

much diversification as in the past&

Exchange rate ris% and foreign exchangetransaction costs within the euro/one willbe eliminated) while interest rates will have

to be similar&



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'ince its introduction in ,---) the euro hasdeclined against many currencies&

#his wea%ness was partially attributed tocapital outflows from Europe) which was in

turn partially attributed to a lac% of

confidence in the euro&

'ome countries had ignored restraint in favorof resolving domestic problems) resulting in

a lac% of solidarity&



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2.02

2./2

2.32

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./2

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4an*!! 4$l*!! 4an*22 4$l*22 4an*2 4$l*2

1/5

1/6

1/,CC7

1/'wF +'wiss Franc1

streng

thensEwe

a%ens


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For more information on the euro) visit( http://www.e$ro.ecb.int/en.html

http://www.ecb.int/

http://pacific.commerce.$bc.ca/xr/e$ro/

Online 3pplication
http://www.euro.ecb.int/en.htmlhttp://www.ecb.int/http://pacific.commerce.ubc.ca/xr/euro/http://pacific.commerce.ubc.ca/xr/euro/http://pacific.commerce.ubc.ca/xr/euro/http://pacific.commerce.ubc.ca/xr/euro/http://pacific.commerce.ubc.ca/xr/euro/http://pacific.commerce.ubc.ca/xr/euro/http://pacific.commerce.ubc.ca/xr/euro/http://pacific.commerce.ubc.ca/xr/euro/http://www.ecb.int/http://www.ecb.int/http://www.ecb.int/http://www.ecb.int/http://www.ecb.int/http://www.euro.ecb.int/en.htmlhttp://www.euro.ecb.int/en.htmlhttp://www.euro.ecb.int/en.htmlhttp://www.euro.ecb.int/en.htmlhttp://www.euro.ecb.int/en.htmlhttp://www.euro.ecb.int/en.htmlhttp://www.euro.ecb.int/en.html


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Government Intervention

Each country has a government agency+called the central ban%1 that may

intervene in the foreign exchange mar%etto control the value of the country2s

currency&

In the 6nited 'tates) the FederalReserve 'ystem +Fed1 is the

central ban%&


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#o lin% to the websites of the central ban%saround the world) visit http://www.bis.org/

cban&s.htm&

Online 3pplication
http://www.bis.org/cbanks.htmhttp://www.bis.org/cbanks.htmhttp://www.bis.org/cbanks.htmhttp://www.bis.org/cbanks.htmhttp://www.bis.org/cbanks.htmhttp://www.bis.org/cbanks.htmhttp://www.bis.org/cbanks.htmhttp://www.bis.org/cbanks.htm


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!entral ban%s manage exchange rates to smooth exchange rate movements#

to establish implicit exchange ratebo$ndaries# and/or to respond to temporary dist$rbances.

Often) intervention is overwhelmed bymar%et forces& :owever) currencymovements may be even more volatile in the

absence of intervention&


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Direct interventionrefers to the exchangeof currencies that the central ban% holds

as reserves for other currencies in theforeign exchange mar%et&

Airect intervention is usually mosteffective when there is a coordinated

effort among central ban%s&



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uantity of

S,

D,D;

Halueof

V,

V;

Fed exchanges = for to strengthen the

uantity of

S;

D,

Halueof

V;

V,

Fed exchanges for =to wea%en the

S,


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Online3pplication

Treasury and Federal Reserve Foreign Exchange Operations

During the third quarter of 2000, the dollar appreciated 8.2 percent

against the euro and 2.0 percent against the yen. On a trade-

weighted basis, the dollar ended the quarter 4.1 percent strongeragainst the currencies of the nited !tates" #a$or trading partners.

On !epte#ber 22, the .!. #onetary authorities inter%ened in the

foreign e&change #ar'ets, purchasing 1.( billion euros against the

dollar. )he operation, which was di%ided e%enly between the .!.)reasury Depart#ent"s *&change !tabili+ation und and the

ederal eser%e !yste#, was coordinated with the *uropean

entral /an' and the #onetary authorities of apan, anada, and

the nited ingdo#.

http(www&federalreserve&gov
http://www.federalreserve.gov/http://www.federalreserve.gov/http://www.federalreserve.gov/http://www.federalreserve.gov/http://www.federalreserve.gov/


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*hen a central ban% intervenes in theforeign exchange mar%et without

ad"usting for the change in money supply)it is said to engaged in nonsterilized

intervention&

In a sterilized intervention) #reasurysecurities are purchased or sold at the

same time to maintain the money supply&



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5onsterilied Intervention

Federal Reserve

Ban%s participatingin the foreign

exchange mar%et

= !=#o'trengthen

the !=(

Federal Reserve


exchange mar%et

= !=#o *ea%enthe !=(


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'terilied Intervention

Federal Reserve


exchange mar%et

= !=#o'trengthen

the !=(

Federal Reserve


exchange mar%et

= !=#o *ea%enthe !=(

=

Financialinstitutionsthat investin #reasurysecurities

#/securities

Financialinstitutionsthat invest

in #reasurysecurities

=

#/securities


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'ome speculators attempt to determinewhen the central ban% is intervening) and

the extent of the intervention) in order tocapitalie on the anticipated results of the

intervention effort&



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!entral ban%s can also engage in indirectinterventionby influencing the factors that

determine the value of a currency& For example) the Fed may attempt to

increase interest rates +and hence boost the

dollar2s value1 by reducing the 6&'& money

supply& 8ote that high interest rates adversely

affects local borrowers.



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Governments may also use foreignexchange controls +such as restrictions

on currency exchange1 as a form ofindirect intervention&



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#he Fed2s ob"ective foropen mar%et operations

has gradually shiftedtoward attaining a

specified level of the

federal funds rate& Find

out more at http://www.federalreserve.gov/fomc/

f$ndsrate.htm&

Online 3pplication
http://www.federalreserve.gov/fomc/fundsrate.htmhttp://www.federalreserve.gov/fomc/fundsrate.htmhttp://www.federalreserve.gov/fomc/fundsrate.htmhttp://www.federalreserve.gov/fomc/fundsrate.htmhttp://www.federalreserve.gov/fomc/fundsrate.htmhttp://www.federalreserve.gov/fomc/fundsrate.htmhttp://www.federalreserve.gov/fomc/fundsrate.htmhttp://www.federalreserve.gov/fomc/fundsrate.htmhttp://www.federalreserve.gov/fomc/fundsrate.htmhttp://www.federalreserve.gov/fomc/fundsrate.htmhttp://www.federalreserve.gov/fomc/fundsrate.htmhttp://www.federalreserve.gov/fomc/fundsrate.htmhttp://www.federalreserve.gov/fomc/fundsrate.htm


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Auring the ,--0/-> 3sian financial crisis)some governments intervened in an

attempt to control their exchange rates&Find out more about the crisis +and the

conseJuences of the intervention efforts1

at http://www.stern.ny$.ed$/globalmacro/&

Online 3pplication
http://www.stern.nyu.edu/globalmacro/http://www.stern.nyu.edu/globalmacro/http://www.stern.nyu.edu/globalmacro/http://www.stern.nyu.edu/globalmacro/http://www.stern.nyu.edu/globalmacro/http://www.stern.nyu.edu/globalmacro/http://www.stern.nyu.edu/globalmacro/http://www.stern.nyu.edu/globalmacro/


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Exchange Rate #arget Kones

4any economists have criticied thepresent exchange rate system because of

the wide swings in the exchange rates ofma"or currencies&

'ome have suggested that target ones beused) whereby an initial exchange rate will

be established with specific boundaries+that are wider than the bands used in fixed

exchange rate systems1&


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Exchange Rate #arget Kones

#he ideal target one should allow rates toad"ust to economic factors without

causing wide swings in international tradeand fear in the financial mar%ets&

:owever) the actual result may be asystem no different from what exists

today&


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Intervention as a Policy #ool

7i%e tax laws and money supply) theexchange rate is a tool which a

government can use to achieve its desiredeconomic ob"ectives&

3 wea% home currency can stimulateforeign demand for products) and hence

local "obs& :owever) it may also lead to

higher inflation&


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3 strong currency may cure high inflation)since the intensified foreign competition

should cause domestic producers torefrain from increasing prices& :owever) it

may also lead to higher unemployment&


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Impact of Government 3ctions on Exchange Rates

Government Intervention inForeign Exchange 4ar%et

Government 4onetary

and Fiscal Policies

Relative InterestRates

Relative InflationRates

Relative 5ationalIncome 7evels

International!apital Flows

Exchange Rates International#rade

#ax 7aws)etc&

uotas)#ariffs) etc&

GovernmentPurchases L 'alesof !urrencies


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Impact of !entral Ban% Interventionon an 45!2s Halue

( ) ( )[ ]( )

+

=n

tt

m

tt

!9

##

ERE(E9+al$e

E +!Fj,t 1 ? expected cash flows in

currencyjto be received by the 6&'& parent at theend of period tE +ERj,t 1 ? expected exchange rate at

which currencyjcan be converted to dollars at

Airect InterventionIndirect Intervention


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Exchange Rate 'ystems ixed Exchange Rate ystem

reely loating Exchange Rate ystem Managed loat Exchange Rate ystem ;egged Exchange Rate ystem ($rrency %oards

Expos$re of a ;egged ($rrency to ation

!hapter Review


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!hapter Review

3 'ingle European !urrency Membership E$ro Transactions


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!hapter Review

Government Intervention Reasons for @overnment


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!hapter Review


international financial management chapter 6 - government influence on exchang rate

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