by Jeff Madura Florida Atlantic University International Financial Management

Government Influence On Exchange Rates 5 5 Chapter

Chapter Objectives  To describe the exchange rate systems used by various governments;  Describe the development and implications of a single European currency;  To explain how governments can use direct intervention to influence exchange rates;  To explain how governments can use indirect intervention to influence exchange rates; and  To explain how government intervention in the foreign exchange market can affect economic conditions.

 As explained in Chapter 4, government policies affect exchange rates.  Some government policies are specifically intended to affect exchange rates. Other policies are intended to affect economic conditions but indirectly influence exchange rates.  Because the performance of an MNC is affected by exchange rates, financial managers need to understand different exchange rate systems and also how the government influences exchange rates. Introduction

Exchange Rate Systems

 A system of managing a nation's currency and exchange rate by linking the national currency to another base currency that is held at a fixed ratio in deposit at domestic banks.  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: 1.Fixed Exchange rate System 2.Freely Floating Exchange rate System 3.Managed Float Exchange rate System 4.Pegged Exchange rate System

In a Fixed Exchange Rate System;  Exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries.  Central bank can reset a fixed exchange rate by devaluing or reducing the value of the currency against other currencies.  Central bank can also revalue or increase the value of its currency against other currencies.  The central bank has to offset any imbalance between demand and supply conditions for its currency in order to prevent its value from changing. 1. Fixed Exchange Rate System

Continued…  Examples:  Bretton Woods Agreement 1944 – Each currency was valued in terms of gold.  Smithsonian Agreement 1971 – 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.

Devaluation Vs Revaluation  In Devaluation the official exchange rate is altered so that a unit of the domestic currency can buy fewer units of foreign currencies While  In Revaluation the official exchange rate is altered so that a unit of the domestic currency can buy more units of foreign currencies

Effects of Devaluation  The gap between official exchange rate and equilibrium exchange rate will be reduced.  Exports become more competitive in the international market.  Imports become more expensive. Effects of Revaluation

 Assume that there are only two countries in the world: the United States and the United Kingdom. Also assume a fixed exchange rate system and that these two countries trade frequently with each other. If the United States experiences a much higher inflation rate than the United Kingdom, U.S. consumers should buy more goods from the United Kingdom and British consumers should reduce their imports of U.S. goods (due to the high U.S. prices). This reaction would force U.S. production down and unemployment up. Example

 It could also cause higher inflation in the United Kingdom due to the excessive demand for British goods relative to the supply of British goods produced. Thus, the high inflation in the United States could cause high inflation in the United Kingdom. Alternatively, a high unemployment rate in the United States will cause a reduction in U.S. income and a decline in U.s purchases of British goods. Consequently, productivity in the United Kingdom may decrease and unemployment may rise. In this case, the United States may "export" unemployment to the United Kingdom. Continued…

In a freely floating exchange rate system;  Exchange rates are determined by market forces without government intervention. Whereas a fixed exchange rate system allows no flexibility for exchange rate movements, a freely floating exchange rate system allows complete flexibility.  A freely floating exchange rate adjusts on a continual basis in response to demand and supply conditions for that currency.  In the modern world, most of the world's currencies are floating; such currencies include the most widely traded currencies: the U.S dollar, the euro, the Norwegian krone, the Japanese yen, the British pound, the Swiss franc etc.. 2. Freely Floating Exchange Rate System

 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. Continued…

Exchange Rate Arrangements

In a managed float exchange rate system;  Governments sometimes intervene to prevent their currencies from moving too far in a certain direction. So exchange rates are allowed to move freely on a daily basis and no official boundaries exist. However, governments prevent the rates from moving too much in a certain direction.  It resembles the freely floating exchange rate system in that exchange rates are allowed to fluctuate on a daily basis and there are no official boundaries. It is similar to the fixed exchange rate system in that governments can sometimes intervene to prevent their currencies from' moving too far in a certain direction. 3. Managed Float Exchange Rate System

 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. Continued…

 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.  A country's exchange rate system under which the government or central bank ties the official exchange rate to another country's currency (or the price of gold) is called PERS.  The purpose of a fixed exchange rate system is to maintain a country's currency value within a very narrow band. Also known as pegged exchange rate. 4. Pegged Exchange Rate System

A pegged exchange rate system;  Is one in which the exchange rate is set and artificially maintained fixed by the government. The rate will be pegged to some other country's currency, usually the U.S. dollar. The rate will not fluctuate on daily basis.  A government has to work to keep their pegged rate stable. Their national bank must hold large reserves of foreign currency to reduce changes in supply and demand. If a sudden demand for a currency were to drive up the exchange rate, the national bank would have to release enough of that currency into the market to meet the demand. They can also buy up currency if low demand is lowering exchange rates. Continued…

Currency Boards and Dollarization

Currency Boards  A currency board is a system for maintaining the value of the local currency with respect to some other specified currency.  E.g. 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  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.

 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.  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. Continued…

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.  A situation where the citizens of a country officially or unofficially use a foreign country's currency as legal tender for conducting transactions. The main reason for dollarization is because of greater stability in the value of the foreign currency over domestic currency.  For example, Ecuador implemented dollarization in 2000.

€  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  European monetary policy is also consolidated because of the single money supply. The Frankfurt-based European Central Bank (ECB) is responsible for setting the common monetary policy.  The ECB aims to control inflation in the participating countries and to stabilize the euro within reasonable boundaries. Continued…

 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.  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. € Continued…

Government Interventions

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.  Central banks manage exchange rates; 1.to smooth exchange rate movements, 2.to establish implicit exchange rate boundaries, and/or 3.to respond to temporary disturbances

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 VS Indirect 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.  When a central bank intervenes in the foreign exchange market without adjusting for the change in money supply, it is said to engaged in non-sterilized intervention.  In a sterilized intervention, Treasury securities are purchased or sold at the same time to maintain the money supply.

Continued…

 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.  Governments may also use foreign exchange controls (such as restrictions on currency exchange) as a form of indirect intervention. Continued…

33 Indirect Intervention The Fed can affect the dollar’s value indirectly by influencing the factors that determine it.

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.  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.

 Exchange Rate Systems  Fixed Exchange Rate System  Freely Floating Exchange Rate System  Managed Float Exchange Rate System  Pegged Exchange Rate System  Currency Boards  Dollarization  Government Intervention  Reasons for Government Intervention  Direct Intervention  Indirect Intervention Chapter Review