Chapter

6
Government Influence
On Exchange Rates

South-Western/Thomson Learning 2006

 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.

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 Exchange Rate Systems
Exchange rate systems can be classified
according to the degree to which the rates
are controlled by the government:
fixed
freely floating
managed float
pegged

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Fixed Exchange Rate System
System: Rates are held constant or allowed
to fluctuate within very narrow bands only.
Examples: Bretton Woods era (1944-1971),
Smithsonian Agreement (1971)
MNCs know the future exchange rates.
Governments can revalue their currencies.
Each country is also vulnerable to the
economic conditions in other countries.

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 Freely Floating
Exchange Rate System
System: Rates are determined by market forces
without governmental intervention.
Each country is more insulated from the
economic problems of other countries.
Central bank interventions just to control
exchange rates are not needed.
Governments are not constrained by the need
to maintain exchange rates when setting new
policies.

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 Freely Floating
Exchange Rate System
Less capital flow restrictions are needed,
thus enhancing market efficiency.
MNCs may need to devote substantial
resources to managing their exposure to
exchange rate fluctuations.
The country that initially experienced
economic problems (such as high inflation,
increased unemployment) may have its
problems compounded.

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 Managed Float
Exchange Rate System
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.
A government may manipulate its
exchange rates such that its own country
benefits at the expense of other countries.

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 Pegged
Exchange Rate System
System: The currencys value is pegged to a
foreign currency or to some unit of
account, and thus moves in line with that
currency or unit against other currencies.
Examples: European Economic
Communitys snake arrangement (1972),
European Monetary Systems exchange
rate mechanism (1979), Mexican pesos
peg to the U.S. dollar (1994)

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 Currency Boards
A currency board is a system for pegging
the value of the local currency to some
other specified currency.
Examples: HK$7.80 = US$1 (since 1983),
8.75 El Salvador colons = US$1 (2000)
A board can stabilize a currencys value.
It is effective only if investors believe that
it will last.

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 Currency Boards
Local interest rates must be aligned with
the interest rates of the currency to which
the local currency is tied.
Note: The local rates may include a risk
premium.
A currency that is pegged to another
currency will have to move in tandem with
that currency against all other currencies.

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 Dollarization

Dollarization refers to the replacement of a

foreign 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.

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 Exchange Rate Arrangements
Floating Rate System:
Afghanistan Hungary Paraguay Sweden
Argentina India Peru Switzerland
Australia Indonesia Poland Taiwan
Bolivia Israel Romania Thailand
Brazil Jamaica Russia United Kingdom
Canada Japan Singapore Venezuela
Chile Mexico South Africa
Euro countries Norway South Korea

Pegged Rate System:

Bahamas Bermuda Hong Kong Pegged to
Barbados China Saudi Arabia U.S. dollar
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 A Single European Currency
The 1991 Maastricht treaty called for a single
European currency the euro.
By June 2002, the national currencies of 12
European countries* had been withdrawn and
replaced with the euro.
* Austria, Belgium, Finland, France, Germany, Greece,
Ireland, Italy, Luxembourg, the Netherlands, Portugal,
Spain
Since then, more European countries have
adopted or are planning to adopt the euro.

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 A Single European Currency
The Frankfurt-based European Central
Bank is responsible for setting European
monetary policy, which is now
consolidated because of the single money
supply.
Each participating country can still rely on
its own fiscal policy (tax and government
expenditure decisions) to help solve its
local economic problems.

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 Government Intervention
Each country has a central bank that may
intervene in the foreign exchange market
to control its currencys value.
A central bank may also attempt to control
the money supply growth in its country.

In the United States, the

Federal Reserve System (Fed)
is the central bank.

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 Government Intervention
Central banks manage exchange rates
to smooth exchange rate movements,
to establish implicit exchange rate
boundaries, and
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.

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 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 and when the
central banks have high levels of reserves
that they can use.

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Effects of Direct Central Bank Intervention
in the Foreign Exchange Market

Fed exchanges $ for Fed exchanges for $

to strengthen the to weaken the

Value Value S1
S1
of of S2

V2 V1
V1
D2 V2
D1 D1

Quantity of Quantity of

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 Government Intervention
When a central bank intervenes in the
foreign exchange market without
adjusting for the change in money supply,
it is said to engage in nonsterilized
intervention.
In a sterilized intervention, the central
bank simultaneously engages in offsetting
transactions in the Treasury securities
markets to maintain the money supply.

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Nonsterilized versus Sterilized Intervention
Nonsterilized Sterilized

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
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 Government Intervention
Some speculators attempt to determine when
the central bank is intervening directly, and
the extent of the intervention, in order to
capitalize on the anticipated results of the
intervention effort.
Central banks can also engage in indirect
intervention by influencing the factors* that
determine the value of a currency.
* Inflation, interest rates, income level,
government controls, expectations

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 Government Intervention
For example, the Fed may attempt to
increase interest rates (and hence boost
the dollars value) by reducing the U.S.
money supply.
Some governments have also used foreign
exchange controls (such as restrictions
on currency exchange) as a form of
indirect intervention.

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 Intervention as a Policy Tool

Like tax laws and the money supply, the

exchange rate is a tool that a government
can use to achieve its desired economic
objectives.
A weak home currency can stimulate
foreign demand for products, and hence
reduce unemployment at home. However,
it can also lead to higher inflation.

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 Intervention as a Policy Tool

A strong currency may cure high inflation,

since it intensifies foreign competition and
forces domestic producers to refrain from
increasing prices. However, it may also
lead to higher unemployment.

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