McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved.

McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Chapter 20 Government Policies toward the Foreign Exchange Market

McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Government Policies Toward the Foreign Exchange Market Two Aspects  Policy toward the level and variability of the (nominal spot) exchange rate. In simple terms, the choice between a floating exchange rate and a fixed exchange rate.  Restrictions (if any) on the use of the foreign exchange market. These restrictions are generally called exchange controls.

McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Decisions for a Government That Has a Fixed Exchange Rate What to peg to?  Gold  U.S. dollar  Other foreign currency  Basket of foreign currencies When to change the fixed rate?  Never (not credible)  Seldom (adjustable peg)  Often (crawling peg) How to defend the fixed rate?  Intervention in the FX market  Exchange control  Alter domestic interest rates  Macroeconomic adjustment

McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 20.1 – Intervention to Defend a Fixed Rate: Preventing Depreciation of the Country’s Currency

McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 20.2 – Official Holdings of Reserve Assets, End of Year, (Billions of U.S. Dollars)

McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 20.3 – Intervention to Defend a Fixed Rate: Preventing Appreciation of the Country’s Currency

McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 20.4 – A Successful Financing of Temporary Deficits and Surpluses at a Fixed Exchange Rate

McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 20.5 – The Best of the Worst: Welfare Losses from Well-Managed Exchange Controls

McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. International Currency Experience Gold Standard,  Gold value of each currency was fixed  Britain was the central country Interwar Instability Bretton Woods System,  Adjustable pegged exchange rates  United States and U.S. dollar were at the center  Eventual dollar crisis Current System  A “nonsystem”—countries can choose almost any exchange rate policy  Many countries use managed floating exchange rates

McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 20.6 – Selected Exchange Rates,

McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 20.7 – Selected Exchange Rates, 1913,

McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 20.8 – Selected Exchange Rates,

McGraw-Hill/Irwin © 2007 The McGraw-Hill Companies, Inc., All Rights Reserved. Figure 20.9 – Exchange Rate Arrangements, August 1, 2005