1. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 1 Chapter 5: Exchange Rate Systems Power Points created by: Joseph F. Greco Ph. D., California State University, Fullerton Mihaylo College of Business and Economics

2. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 2 Chapter 5: Exchange Rate Systems 5.1Alternative Exchange Rate Arrangements and Currency Risk 5.2Central Banks 5.3Flexible Exchange Rate Systems 5.4Fixed Exchange Rate Systems 5.5Limited-Flexibility Systems: Target Zones and Crawling Pegs

3. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 3 5.1Alternative Exchange Rate Arrangements and Currency Risk Alternative Arrangements: Overview Exchange Rate Systems Around the World Floating Currencies Fixed, or Pegged, Currencies Special Pegged Arrangements Target Zones and Crawling Pegs Currency Risks in Alternative Systems Quantifying Currency Risks Currency Risks in Floating Systems Currency Risk in Target Zones Currency Risk in Pegged Exchange Rate Systems Currency Risk in Currency Boards and Monetary Unions

4. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 4 5.1Alternative Exchange Rate Arrangements and Currency Risk Exchange Rate Systems Around the World

5. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 5 Exhibit 5.1Exchange Rate Systems Around the World

6. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 6 Exhibit 5.1Exchange Rate Systems Around the World

7. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 7 5.1Alternative Exchange Rate Arrangements and Currency Risk Floating Currencies Are determined by the market forces of supply and demand

8. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 8 5.1Alternative Exchange Rate Arrangements and Currency Risk Fixed, or Pegged, Currencies Fixed currencies Pegged currencies Basket of currencies Special drawing right European currency unit (ECU)

9. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 9 5.1Alternative Exchange Rate Arrangements and Currency Risk Special Pegged Arrangements Target Zones and Crawling pegs Currency Risks in Alternative Exchange Rate Systems Quantifying Currency Risks Currency Risks in Floating Exchange Rate Systems

10. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 10 Exhibit 5.2 Currency Risk in Alternative Exchange-rate Systems

11. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 11 Exhibit 5.3 Contrasting the FRF/DEM and CAD/USD Exchange Rates Panel A: Exchange Rate Changes Over Time

12. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 12 Exhibit 5.3 Contrasting the FRF/DEM and CAD/USD Exchange Rates Panel B: Histogram of Log Changes

13. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 13 5.1Alternative Exchange Rate Arrangements and Currency Risk Currency Risk in Target Zones Currency Risk in Pegged Exchange Rate Systems Currency Risk in Currency Boards and Monetary Unions

14. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 14 Exhibit 5.4 Exchange Rate Arrangements Panel A: April 2006 Total: 186

15. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 15 Exhibit 5.4 Exchange Rate Arrangements Panel B: March 1990 Total: 151

16. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 16 5.2Central Banks The Central Bank’s Balance Sheet Bank Reserves and Currency in Circulation Required reserves Monetary base Domestic Credit Open market operations

17. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 17 Exhibit 5.5 Central Bank Balance Sheet

18. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 18 5.2Central Banks Official Reserves Foreign exchange reserves Money Creation and Inflation Seigniorage The Impossible Trinity Foreign Exchange Interventions Non-Sterilized Interventions Sterilized Interventions

19. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 19 Exhibit 5.6 Foreign Exchange Reserves

20. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 20 Exhibit 5.7 Sterilized and Non-Sterilized Foreign Exchange Intervention

21. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 21 5.2Central Banks How Do Central Banks Peg a Currency? Pegging the Exchange Rate

22. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 22 Exhibit 5.8 Fixing the $/£ Exchange Rate

23. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 23 5.3Flexible Exchange Rate Systems The Effects of Central Bank Interventions Direct Effects of Interventions Indirect Effects of Interventions Empirical Evidence on the Effectiveness of Interventions

24. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 24 5.4Fixed Exchange Rate Systems Fixed Exchange Rate Systems: Overview The International Monetary System Before 1971: A Brief History Individual Incentives Versus Aggregate Incentives Special Drawing Rights Pegged Exchange Rate Systems in Developing Countries Illegal Currency Markets Why Not Simply Float? Currency Boards Dollarization

25. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 25 Exhibit 5.9 The Effects of Foreign Exchange Interventions

26. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 26 5.4Fixed Exchange Rate Systems The International Monetary System Before 1971: A Brief History The Gold Standard Hyperinflation and the Interwar Period The Bretton Woods System

27. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 27 5.4Fixed Exchange Rate Systems Individual Incentives Versus Aggregate Incentives

28. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 28 5.4Fixed Exchange Rate Systems Special Drawing Rights An alternative reserve asset with the same gold value as the dollar

29. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 29 5.4Fixed Exchange Rate Systems Pegged Exchange Rate Systems in Developing Countries Illegal Currency Markets

30. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 30 Exhibit 5.10 Pegging an Exchange Rate in a Developing Country

31. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 31 5.4Fixed Exchange Rate Systems Why Not Simply Float? Currency Boards Dollarization

32. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 32 Exhibit 5.11 The Balance Sheet of a Currency Board

33. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 33 5.5 Limited-Flexibility Systems: Target Zones and Crawling Pegs Target Zones –Speculative Attacks –Defending the Target Zone –Lead-Lag Operations Crawling Pegs

34. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 34 Exhibit 5.12 An Example of a Target Zone

35. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 35 Exhibit 5.13 An Example of a Crawling Peg

36. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 36 5.6 How to See an Emu Fly: The Road to Monetary Integration in Europe The European Monetary System (EMS) –The ERM –Intervention Rules –Realignment Rules

37. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 37 5.6 How to See an Emu Fly: The Road to Monetary Integration in Europe On ECUs, Euros, and Franken –The Politics of Naming the Euro

38. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 38 Exhibit 5.14 Composition of the ECU Basket

39. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 39 5.6 How to See an Emu Fly: The Road to Monetary Integration in Europe Was the EMS Successful? –Day-to-day variability was down –Inflation and interest differentials narrowed –Asymmetric adjustments

40. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 40 5.6 How to See an Emu Fly: The Road to Monetary Integration in Europe The Maastricht Treaty and the Euro –ERM II

41. Copyright © 2009 Pearson Education, Inc. Publishing as Prentice Hall 41 5.6 How to See an Emu Fly: The Road to Monetary Integration in Europe (Advanced) Pros and Cons of a Monetary Union –Optimum currency areas –Is Europe an Optimum currency area?