Chapter 5
Govt. Influence on Exchange
Rate
Rashedul Hasan
Exchange Rate Systems
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Exchange rate systems normally fall into
one of the following categories:
Fixed
Freely floating
Managed float
Pegged
Fixed Exchange Rate System
In a fixed exchange rate system, exchange
rates are either held constant or allowed to
fluctuate only within very narrow bands.
• The Bretton Woods era (1944-1971) fixed
each currency’s value in terms of gold.
• The 1971 Smithsonian Agreement which
followed merely adjusted the exchange rates
and expanded the fluctuation boundaries.
The system was still fixed.
Advantages of Fixed Exchange
Rate System
• In a fixed exchange rate environment MNCs may
be able to engage in International trade without
worrying about the future exchange rate.
Therefore, Work becomes easier for the MNCs.
• For example, when General Motors (GM)
imported material for foreign countries during the
BrettonWood era, it could anticipate the amount of
Dollar it would need to pay the import bill.
Disadvantages of Fixed
Exchange Rate System
• There is still risk that the Government will
alter the value of specific currencies.
Although the MNCs are not exposed to
continual movement of an exchange rate, it
does face the possibility that its Govt. will
devalue or revalue its currency.
• Another disadvantage is each country may
become more vulnerable to the economic
conditions in other countries.
Freely Floating Exchange Rate
System
In a freely floating exchange rate system,
exchange rates are determined solely by
market forces. A freely floating exchange
rate system adjusts on a continual basis in
response to demand and supply conditions
for the currency.
Advantages of Freely Floating
Exchange Rate System
• Each country may become more insulated against
the economic problems in other countries.
• Central bank interventions that may affect the
economy unfavorably are no longer needed.
• Governments are not restricted by exchange rate
boundaries when setting new policies.
• Less capital flow restrictions are needed, thus
enhancing the efficiency of the financial market.
Disadvantages of Freely Floating
Exchange Rate System
• 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,
increasing unemployment rate) may have its
problems compounded.
Managed Float Exchange Rate
System
In a managed (or “dirty”) float exchange
rate 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.
Managed Float Exchange Rate
System
At times the Govt. of various countries like Brazil,
Russia, South Koria, and Venezuela have imposed
bands around their currency ti limit its degree of
mmovement. Later, however, they removed the
bands when they found they could not maintain
the currency’s value within the bands.
The one disadvantage associated with it that, a
government may manipulate its exchange rates
such that its own country benefits at the expense
of others.
Pegged Exchange Rate System
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.
Some Asian countries such as Malaysia and
Thailand had pegged their currency’s value to the
dollar. During the asian crisis, though, they were
unable to maintain the peg and allowed their
currencies to float against dollar.
Pegged Exchange Rate System
The European Economic Community’s snake
arrangement (1972-1979) pegged the currencies of
member countries within established limits of each other.
The European Monetary System which followed in 1979
held the exchange rates of member countries together
within specified limits and also pegged them to a
European Currency Unit (ECU) through the exchange
rate mechanism (ERM). The ERM experienced severe
problems in 1992, as economic conditions and goals
varied among member countries.
Pegged Exchange Rate System
In 1994, Mexico’s central bank pegged the peso to
the U.S. dollar, but allowed a band within which
the peso’s value could fluctuate against the dollar.
By the end of the year, there was substantial
downward pressure on the peso, and the central
bank allowed the peso to float freely.
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.
In the Bangladesh, Bangladesh Bank is the central
bank.
• To link to the websites of the central banks around
the world, visit http://www.bis.org/cbanks.htm.
Reasons for Govt. Intervention
Central banks manage exchange rates,
• to smooth exchange rate movements,
• to establish implicit exchange rate
boundaries, and/or
• to respond to temporary disturbances.
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
movement over time. It may encourage
International trade by reducing exchange rate
uncertainty. Moreover, smoothing currency
movements may reduce fears in the financial
markets and speculative activities that could
cause a major decline in a currency’s value.
Establish implicit exchange
rate boundaries
Some central bank attept to maintain their home
currency rates within some unoficial or implicit
boundaries. Analysts are commonly quoted as
forecasting that a currency will not fall bellow or
rise above a particular benchmark value because
the central bank would intervane to prevent that.
Respond to temporary
disturbances
In some cases, a central bank may intervane
to insulate a currency’s value from a
temporary disturbance.
Types of Intervantion
Direct vs. Indirect Intervantion
Direct intervention refers to the exchange of
currencies that the central bank holds as reserves
for other currencies in the foreign exchange
market. By “flooding the marke with dollars” in
this manner, the central bank of U.S. puts pressure
on the dollar. If the central bank of U.S. wants to
strengthen the dollar, it can exchange foreign
currencies for dollars in foreign exchange market,
thereby putting upward pressure on the dollar.
Direct intervention is usually most effective when
there is a co-ordinated effort among central banks.
The effect on direct intervention on the value of the
British pound are illustrated as follows
Fed exchanges $ for £
to strengthen the £
Value
of £
V2
V1
S1
D2
D1
Quantity of £
Fed exchanges £ for $
to weaken the £
Value
of £
V1
V2
S1
S2
D1
Quantity of £
Nonsterilized intervention vs.
Sterilized intervention
Nonsterilized
When a central bank intervenes in the foreign
exchange market without adjusting for the change
in money supply, it is said to engaged in
nonsterilized intervention.
For example, if the Federal Reserve bank
exchanges ollars for foreign currencies in in the
foreign exchange market in an attempt to
strengthen foreign currencies (weaken dollar), the
dollar money supply will increase.
Nonsterilized Intervention
Federal Reserve
To
Strengthen
the C$:
$
C$
Banks participating
in the foreign
exchange market
Federal Reserve
To Weaken
the C$:
$
C$
Banks participating
in the foreign
exchange market
Sterilized intervention
In a sterilized intervention, Treasury securities are
purchased or sold at the same time to maintain the
money supply.
For example, if the Federal Reserve Bank desires to
strengthen foreign currencies (weaken the dollar)
without affecting the dollar money supply it may either
exchange dollars for foreign currencies or sells some of
its holdings of Treasury securities for dollars. The net
effect is an increase in investor’s holdings of Treasury
securities and a decrease in bank foreign currency
balance.
Sterilized Intervention
T- securities
Federal Reserve
To
Strengthen
the C$:
$
C$
$
Banks participating
in the foreign
exchange market
$
Federal Reserve
To Weaken
the C$:
$
C$
Financial
institutions
that invest
in Treasury
securities
T- securities
Banks participating
in the foreign
exchange market
Financial
institutions
that invest
in Treasury
securities
Indirect Intervantion
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.
Governments may also use foreign exchange
controls (such as restrictions on currency
exchange) as a form of indirect intervention.
Exchange Rate Target Zones
Many economists have criticized the present
exchange rate system because of the wide swings
in the exchange rates of major currencies.
Some have suggested that target zones be used,
whereby an initial exchange rate will be
established with specific boundaries (that are
wider than the bands used in fixed exchange rate
systems).
Exchange Rate Target Zones
The ideal target zone should allow rates to
adjust to economic factors without causing
wide swings in international trade and fear
in the financial markets.
However, the actual result may be a system
no different from what exists today.
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.
Currency Boards
A currency board is a system for maintaining the value
of the local currency with respect to some other
specified currency.
For example, 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 1991.
For a currency board to be successful, it must have
credibility in its promise to maintain the exchange rate.
Currency Boards
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.
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.
For example, Ecuador implemented
dollarization in 2000.