INTERNATIONAL FINANCE
Week 9: Lecture 8 and 9
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LEARNING GOALS
• The effects of exchange rates on the macro economy
and in particular to the economics of fixed versus
floating exchange rate systems as part of the
operation of macroeconomic policy in a country.
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Measuring the exchange rate
Exchange rate prices are expressed in various ways:
• Spot Exchange Rate - the spot rate is the actual exchange rate
for a currency at current market prices. This is determined by the
FOREX market on a minute-by-minute base on the basis of the flow
of supply and demand for any one particular currency.
• Forward Exchange Rate - a forward rate involves the delivery
of currency at some time in the future at an agreed rate. Companies
wanting to reduce the risk of exchange rate uncertainty by buying
their currency ‘forward’ on the market often use this.
• Bi-lateral/Nominal Exchange Rate (the value of two
currencies) - this is simply the rate at which one currency can be
traded against another. Examples include:
– Sterling/US Dollar, $/YEN or Sterling/Euro
• Real Exchange Rate - describes how many items of a good or
service in one country can be traded for one of that good or service
in another country. For example, a real exchange rate might state
how many European bottles of wine can be exchanged for one US
bottle of wine.. A rise in the real exchange rate implies a worsening
of international competitiveness for a country.
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• In previous lectures we presented how currencies are
exchanged and what seems to determine the exchange
rate if the determination is left mainly to market forces .
• For better or worse many governments do not usually
just let the private market set the exchange rate. To a
certain extent governments have policies toward the
foreign exchange market.
But what are the reasons that a government might
want to affect exchange rates?
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Reasons that Governments want
to influence exchange rates.
1. Exchange rates if left to private market forces, sometimes
fluctuate a lot. Also they may occasionally be influenced by
bandwagons between investors or speculators ( gamblers).
Exchange rates are very important prices – they can affect
the entire range of a country’s international transactions.
One objective for government policy is to reduce
variability in exchange rates.
The bandwagon effect: some investors predict that the recent trend of the
exchange rate will continue in the near future as well: the next minutes, hours,
days, weeks. For instance currencies that have been appreciating are expected
to continue to do so. The recent actual increase in the exchange rate value of a
country’s currency leads some investors to expect further increases
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2. A government may want to keep the exchange rate value of
its currency low preventing appreciation or encouraging
depreciation. Why? This benefits certain activities or groups
within the country, including the country’s exporters.
3. Or in a different setting a government may want to do the
opposite: keep the exchange rate value of its currency high,
preventing depreciation or encouraging appreciation. This
can benefit other activities or groups-for instance buyers of
imports. It also can be used as part of an effort to reduce
domestic inflation by using the competitive pressure of low
import prices.
4. In addition, the government policy may reflect other relatively
noneconomic goals. The government may believe that it is
defending national honor or encouraging national pride by
maintaining a stable exchange rate or a strong currency
internationally. Devaluation or depreciation may be feared as a
confirmation of the weakness or inability of the government
in
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selecting policies.
Exchange rate systems
• Free Floating Exchange Rate The value of a currency is
determined only by market demand and supply of the
currency. Both trade flows and capital flows affect the
exchange rate under a floating system. No target for the
exchange
rate
is
set
by
the
Government
There is no need for official intervention in the currency
market by the central bank
• Managed Floating Exchange Rate The value of the
currency is determined by market demand for and supply of
the currency. However Central banks may try to calm down
big changes in exchange rates on a day-to-day basis.
Some currency market intervention might be considered as
part of macro-economic demand management (e.g. a desire
for a slightly lower currency to boost export demand or the
desire for a strong currency to control inflationary pressures)
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• Semi Fixed Exchange Rates The exchange rate is given a
specific target. The currency can move between permitted
bands
of
fluctuation
on
a
day-to-day
basis
Exchange rate becomes a target of economic policy-making
(interest rates are set to meet the exchange rate target). The
Central Bank might have to intervene to maintain the value
of the currency within the set targets if it moves outside the
agreed range. Re-valuations are seen as a last resort
• Fully Fixed Exchange Rates The government makes a
commitment to a fixed exchange rate. The exchange rate is
pegged. There are no fluctuations from the central rate.
This system achieves exchange rate stability but perhaps at
the expense of domestic stability in the economy. A solution
for the domestic stability is that a country can improve its
competitiveness by reducing its costs below that of other
countries – knowing that the exchange rate will remain
stable.
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Two aspects: Rate flexibility and
Restrictions on use
Government policies toward the foreign exchange market
are of two types:
• (a) Those policies that are directly applied to the
exchange rate it self.
• (b) Those policies that directly state who may use the
foreign exchange market and for what purposes
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The first type of policy acts directly on price – the exchange rate –
while the second type acts directly on quantity- by limiting some
people’s ability to use the foreign exchange rate. Any one policy has
impacts on both price and quantity in the market even though the
policy directly acts on only one of these.
• (a) the first policy allows the governments to choose between floating
and fixed exchange rates.
• (b) the second policy allows governments to choose between
restriction in access to the FEM and no restriction. No restriction is
the case where everyone is free to use the foreign exchange market:
the country’s currency is fully convertible into foreign currency for all
uses, for both trade in goods and services (current account
transactions) and international financial activities. The other choice of
this policy is the exchange control: the government places some
restrictions on use of foreign exchange market. In the most extreme
form of
exchange control anyone who wants to obtain foreign
exchange must request it from the authority which then determines
whether to approve the request.
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Common forms of exchange control is when government :
• Permits use of the FEM for all payments for exports and imports of
goods and services (so currency is convertible for current account
transactions)
• Imposes some form of capital controls, by placing limits or requiring
approvals for payments related to some international financial
activities.
• Also another less extreme form of restriction is limits on the use of
FEM for transactions related to large imports of consumer luxury
goods.
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Distinguish between a fixed and a managed
floating exchange rate system
Floating exchange rates
When a country uses a floating exchange rate system:
* The value of the currency is determined purely by demand
and supply of the currency.
.
* Trade flows and capital flows affect the exchange rate
under a floating system.
.
* There is no target for the exchange rate and no
intervention in the market by the central bank.
This policy choice results in a clean float in which
governments make no direct attempts to influence foreign
currency values.
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The Bank of England has not intervened to influence the
pound’s value since it became independent in September
1992 when sterling exit the Exchange Rate Mechanism
(ERM).
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• Even when the country’s exchange rate policy is to
permit flexibility by floating the rate, the government often
is not willing to simply let the rate go whether private
supply and demand drive it. In contrast the government
often tries to have a direct impact on the rate through
official intervention. By this we mean that the monetary
authority enters the FEM to buy or sell foreign currency in
exchange for domestic currency. Through this
intervention the government hopes to change the deal of
supply and demand. This policy approach – an exchange
rate that is generally floating (or flexible) but with the
government willing to intervene to attempt to influence
the market rate - is called managed float or a dirty float.
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• Often the government is attempting to ‘act’ against the wind
so as to control movements in the floating rate.
For example if the exchange rate value of the country’s
currency is rising and that of the foreign currency falling
then the authorities intervene to buy foreign currency and
sell domestic currency. They hope that the intervention and
the extra supply of domestic currency can slow or stop their
own currency’s rise in value or likewise that the demand for
foreign currency can slow or stop its decline.
However most governments that choose a floating
exchange rate policy also do manage or ‘dirty’ the float to
some extent.
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Characteristics of Managed floating exchange rate:
When a country uses a managed floating exchange rate system:
• The value of a currency from day to day is determined by market demand for
and supply of the currency
.
* Some currency market intervention might be considered as part of demand
management (e.g. a desire for a slightly lower currency value to increase
export
demand)
.
* Intervention can either be explicit (direct) i.e. a central bank buys foreign
currency when it wants the domestic currency to depreciate
* Or Intervention might come from changes in policy interest rates so as to
affect the net flows of short term banking money (so- called “hot money”)
* Verbal intervention is when a central bank tries to send a signal to the
currency markets that it wishes the currency to move in a certain direction and
that it stands by ready to engage in official market intervention if this does not
happen.
• In 2012 a growing number of countries are moving towards managed or “dirty”
floating systems. Brazil, Japan, Switzerland and Norway have all intervened in
the currency markets in recent months. Brazil in particular has claimed that
developed nations are seeking to undervalue their currencies to create a
competitive advantage in the world economy and stimulate their economies.
For this reason they have introduced extra taxes on the interest paid on
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foreign deposits in their banking system.
Fixed Exchange rate
• If the government chooses the policy of a fixed exchange rate then the
government sets the exchange rate that it wants. Often some flexibility
is permitted within a range called band around the chosen fixed rate
which is called the par value or central value. However the flexibility is
generally more limited than would occur if the government instead
permitted a floating rate.
• In the case of fixed exchange rate the government faces three major
questions:

To what does the government fix the value of its currency?

When or how often does the country change the value of its fixed
rate?

How does the government defend the fixed value against any
market pressures pushing toward some other exchange value?
Chara Charalambous - CDA
COLLEGE
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What to fix to?
• A fixed rate means that the value of the country’s currency is
fixed to something else. A century ago this something was gold:
several countries were fixing the value of their currency to
specific amount of gold then the exchange rates between the
currencies were fixed at the rates resulting by their gold values.
So currencies were tied to the same thing- gold- and then tied
to each other. In principle any other commodity or group of
commodities could serve the same purpose as gold did.
• The country could choose to fix the value of its currency to
some other currency rather than to a commodity.
Since the World War II many countries have often fixed the
value of their currency to the US dollar. Any other currency can
serve the same purpose.
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• A fixed exchange rate is usually used to stabilize the
value of a currency against the currency it is pegged to.
This makes trade and investments between the two
countries easier and more predictable and is especially
useful for small economies in which external trade forms
a large part of their GDP.
• It can also be used as a means to control inflation.
However, as the reference value rises and falls, so does
the currency pegged to it. In addition, according to the
Mundell–Fleming model, with perfect capital mobility, a
fixed exchange rate prevents a government from using
domestic monetary policy in order to achieve
macroeconomic stability.
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• Or a country could choose to fix the value of its currency
not to one other currency but to the average value of a
number of other currencies – a basket of other currencies.
Why? The logic is the same as that of diversifying a
portfolio – not putting all your eggs in one basket. If a
country fixes to one single other currency then it will move
in the same level as the other currency and this will be a
disadvantage in cases were the other currency
experience extreme changes against any third countries
currencies.
• Therefore fixing to a basket of currencies the effect of
extreme changes is controlled since the average value is
kept steady.
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What basket of currencies might the country fixed to?
• There is one ready made basket – the special drawing
right (SDR) - a basket of the four major currencies in the
world (US dollar, Euro, Japanese Yen and British
pound). Or a country can create its own basket and
include the currencies of its major trading partners. No
country today fixes its currency to gold or any other
commodity but it fixes the exchange rate value of its
currency to one or more other currencies.
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When to Change the Rate?
• When a country has chosen to fix its exchange rate and
chosen to what to fix to faces the question of when to
change the fixed rate.
• Why might a government want to change the exchange
value of its currency? Most
probably nothing is fixed
forever. It might do so in order to promote, for example,
greater export volume. A fixed exchange rate system does
not imply that the rate will stay at that same level all the
time. The government may decide to change the rate
because of adverse effects on the economy. For example, if
the currency is overvalued exporting industries will become
less internationally competitive, affecting international trade
and the balance of payments, and the government might
take action to devalue the exchange rate.
• On this basis we often use the term pegged exchange rate in place of
fixed exchange rate, and it indicates that the government has some
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ability to move the peg value. (Peg=attach, fix, tight, connect)
• A devaluation of a currency occurs under a
fixed exchange rate system when there is on
purpose (intentional,planned) action taken by a
government to decrease its value in the forex
market.
OR
• Alternatively a revaluation occurs under a fixed
exchange rate system when there is on
purpose action taken by the government to
increase the value of the currency in the forex
market.
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What is a pegged exchange rate?
• The term pegged exchange rate refers to setting a targeted value for a
country’s foreign exchange. A pegged, rate is a rate the government (or
central bank) sets and maintains as the official exchange rate. A set
price will be determined against a major world currency (usually the
U.S. dollar, but also other major currencies such as the euro, the yen or
a basket of currencies). In order to maintain the local exchange rate, the
central bank buys and sells its own currency on the foreign exchange
market in return for the currency to which it is pegged.
If, for example, it is determined that the value of a single unit of local
currency is equal to US$3, the central bank will have to ensure that it
can supply the market with those dollars. In order to maintain the rate,
the central bank must keep a high level of foreign reserves. This is a
reserved amount of foreign currency held by the central bank that it can
use to release (or absorb) extra funds into (or out of) the market. This
ensures an appropriate money supply, appropriate fluctuations in the
market (inflation/deflation) and finally, the exchange rate. The central
bank can also adjust the official exchange rate when necessary.
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• The government sets the price of the exchange rate at
the par value it considers the most appropriate for the
country and also sets a band around the par value so as
the exchange rate can move without facing the problem
to change all the time the pegged rate value.
• Governments attempt to keep the value fixed for
relatively long periods of time to reduce trade
uncertainties.
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What must the Central Bank do to maintaindevaluate the value of the domestic currency at the
desired rate?
Just like any other product, the value of a currency goes up and
down based on supply & demand. So basically, a country can
devalue its own currency by selling/releasing more of it into the
world. It can do this in many ways, including just printing cash and
dumping it onto the foreign exchange market. It can allow more
imports into the country or put taxes on exports, forcing consumers to
purchase foreign products with their cash - hence increasing the
supply of their currency abroad. It can do any number of things to
increase the amount of its currency abroad and devalue it.
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What must the Central Bank do to maintain- revaluate
the value of the domestic currency at the desired
rate?
If a government wants its currency to be increased in value buys its
own currency from the foreign exchange market, at the high price it
wants to reach its currency, by selling its reserves of foreign currency.
In this way the government is removing domestic currency from the
economy. This will tend to reduce the domestic money supply and so
the price of the currency will go up. If the government wants to
reverse this effect of low supply of domestic currency takes another
action called sterilization to restore the domestic money back into the
economy.
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• The government may change the pegged rate if a
substantial disequilibrium in the country’s international
position develops (e.g., demand for the currency is too
weak to maintain the desired value). This approach is
called adjustable peg.
• Also a country might choose a different way to peg its
currency, the crawling peg. A crawling peg can be
changed often (monthly, say) according to a set of
indicators or the judgment of the country’s monetary
authority.
• Indicators:
– The difference of inflation rates: the difference
between the country’s inflation rate and the inflation
rate of the country whose currency it pegs to.
– Growth of the country’s money supply indicates the
inflation pressure.
• e.t.c
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‘Defending a Fixed Exchange Rate’ or
in other words ‘How the Central Bank
manipulates the value of the currency’?
• The third major question faces a country that has chosen
a fixed exchange rate is how to defend its fixed rate. The
pressures of private or nonofficial supply and demand in
the FEM may sometimes drive the exchange rate toward
values that are not within the band. The government then
must use some means to defend the pegged rate – to
keep the actual exchange rate within the band.
• There are four basic ways that a government uses to
defend the fixed rate that it has been announced.
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Ways that a government uses to manipulate exchange
rate
1.
2.
To buy or sell foreign currencies in exchange for
domestic currency (in order to influence the existing
exchange rate). Therefore a government must have
foreign exchange reserves.
The government can impose some form of exchange
control by harmonizing demand or supply in the
market. A way is to use trade controls such as tariffs or
quotas to attempt to achieve this result.
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3. The government can change domestic interest rates to
influence short-term capital flows of ‘hot money’ and
consequently influencing the exchange rate, as it is
changing the supply and demand position in the market.
What is ‘hot money’?
Answer: Money that flows regularly between financial markets as investors
attempt to ensure they get the highest short-term interest rates possible.
Hot money will flow from low interest rate yielding countries into higher
interest rates countries by investors looking to make the highest return.
These financial transfers could affect the exchange rate if the sum is
high enough and can therefore impact the balance of payments.
How can higher (i) rates keep the currency value up?
Answer: As soon as the institution reduces interest rates or another
institution offers higher rates, investors with "hot money" withdraw their
funds and move them to another institution with higher rates. Investors
will purchase the nation’s currency to make short-term investments in
the country because they will give them higher return, bidding in this
way the value of the currency upward.
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4.
The government can also make long-term adjustments of its
macroeconomic policies (monetary and/or fiscal policy). In
this way it can adjust export abilities or the demand for
imports or change the direction of international capital flows.
Taxation of foreign deposits in banks cut the profit from the ‘hot money’
inflows. Foreigners will move their investments causing the currency to be
devaluate (reduce in value). The devaluation of currency affects trade:
exports are profited.
Why does inflation put downward pressure on a country’s exchange rate?
Non-inflating countries are unwilling to pay more and more to buy an
inflating country’s goods and services. Reduced demand for the inflating
currency will make it depreciate.
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A fifth way is to give up rather than to defend:
Following this option the country can change its
fixed rate (devaluating or revaluing its currency)
or switch / change to a floating exchange rate (in
this case the currency will immediately
depreciate or appreciate)
The four first ways displayed above are not
excluding each other but in fact a country can
use several methods at the same time. For
example changing interest rates to influence
short-term capital flows relates to overall
macroeconomic management.
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Figure 1:
At the equilibrium exchange
rate is $A1.00 = $US0.50.
The
equilibrium
quantity
supplied and demanded is
Q1 Australian dollars.
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Figure 2 : A currency appreciation
If the demand increases for
Australian dollars.
If the supply decreases for
Australian dollars.
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Figure 3 : A currency depreciation
If the demand decreases for
Australian dollars.
If the supply increases for
Australian dollars.
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• Competitive devaluations
Competitive devaluations occur when a country
intentionally intervenes in foreign exchange markets to
drive down the value of their currency to provide a
competitive boost to demand and jobs in their export
industries.
For nations with persistent trade deficits and rising
unemployment a competitive devaluation of the
exchange rate can become an attractive option - but
there are risks. One is that devaluing an exchange rate
can be seen by other countries as a form of trade (or
crisis) protectionism that invites some form of penalizing
action. Cutting the exchange rate makes it harder for
other countries to export their goods and services.
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Comparison between Flexible and Fixed
Exchange Rate Systems
Flexible exchange rate
exchange rate is
determined by demand
for and supply of
foreign currency
Fixed exchange rate
the government fixes
the foreign exchange
rate by buying and
selling of foreign
exchange
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Flexible exchange rate
Fixed exchange rate
• depreciation or
appreciation of a
currency is determined
by the market forces
• devaluation or
revaluation of a
currency is determined
by the government
• speculation in foreign
exchange market is
common
• speculation occurs
when there is rumour
about the change in
government policy
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Flexible exchange rate
Fixed exchange rate
• self-adjusting
mechanism operates to
eliminate external
disequilibrium by
change in foreign
exchange rate
• self-adjusting
mechanism operates
through the change in
money supply,
domestic interest rate
and domestic price
In a heavily managed float the exchange rate may show little
flexibility – it is almost pegged, even though this is not the
way that the government describes its choice.
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Appendix:
The European Exchange Rate Mechanism
• The European Exchange Rate Mechanism (ERM) was a system
introduced by the European Community in March 1979, as part of
the European Monetary System (EMS), to reduce exchange rate
variability and achieve monetary stability in Europe, in preparation
for Economic and Monetary Union and the introduction of a single
currency, the euro, which took place on 1 January 1999.
• After the adoption of the euro, policy changed to linking currencies
of countries outside the Eurozone to the euro (having the common
currency as a central point). The goal was to improve stability of
those currencies, as well as to gain an evaluation mechanism for
potential Eurozone members. This mechanism is known as ERM2
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Pound sterling’s forced
withdrawal from the ERM
• The United Kingdom entered the ERM in October 1990,
but was forced to exit the programme within two years
after the pound sterling came under major pressure from
currency speculators. The resulting crash of 16
September 1992 was subsequently named "Black
Wednesday". There has been some revision of attitude
towards this event given the UK's strong economic
performance after 1992, with some commentators
naming it "White Wednesday
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