BFW3331 Suggested answers for Tutorial 1 Week 2

BFW 3331 Suggested Solutions to Tutorial Questions

Tutorial 1: Introduction to International Finance and International Financial System

Q1 Discuss the following exchange rate regimes:

a) Fixed exchange rate regime: The country pegs (fixes) its currency (formally or de facto) at a fixed rate to a major currency like USD or to a basket of currencies, where the exchange rate fluctuates within a narrow margin or at most ± 1% around a central rate.

b) Free floating exchange rate regime: The exchange rate is market determined, with degree of fluctuations based on the demand and supply of the domestic currency against another foreign currency. In this type of regime, the central bank does not intervene to manage the domestic currency fluctuation.

c) Target zone exchange rate arrangement: The country allows it currency to fluctuate within a narrow band (normally ± 1%) against other foreign currency. The exchange rate is adjusted periodically to reflect the changes in economic fundamentals.

d) Managed float exchange rate arrangement: The central bank (or monetary authority) influences the movements of the exchange rate through active intervention in the foreign exchange market. This arrangement is also referred as dirty float.

Monash University Malaysia, BFW3331, S1 2014 1

BFW3331 Suggested answers for Tutorial 1 Week 2

2. Bekaert & Hodrick. Chapter 5 page 171 Questions: 3, 4, 5, 6, 7, 8, 12, and 15.

3. What is likely to be the most credible exchange rate system?

Answer:

Among fixed exchange rate systems, a monetary union with a common currency is likely the most credible exchange rate system.

4. How can a central bank create money?

Answer :

First, because the central bank is the only authorized government agency to print the currency of a country, it can actually print money to be circulated through financial institutions, thereby increasing the money supply.

Second, the central bank can create money by increasing the reserve accounts financial institutions hold with it. For example, if the central bank buys an asset (a government bond says) from a financial institution, it credits the financial institution’s reserve account at the central bank for the purchase price of the bond. Because this financial institution can now use this credit to its account to lend money to individuals and businesses, the central bank has, essentially, created money.

5. What are official international reserves of the central bank?

Answer:

Official reserves consist of three major components: (i) foreign currency exchange reserves, (ii) gold reserves, and (iii) IMF-related reserve assets, with the first being by far the most important component. Foreign exchange reserves are all the foreign currency denominated assets the central bank holds, and mostly consist of foreign government bonds.

Monash University Malaysia, BFW3331, S1 2014 2

BFW3331 Suggested answers for Tutorial 1 Week 2

6. What is likely to happen if a central bank suddenly prints a large amount of new money?

Answer :

There are theories that predict that changes in the money supply can have real effects on the economy in the short run. It is likely that if the central bank showers the economy suddenly with large supply of money, the only result will be higher inflation domestically. This is because the demand for money ultimately depends on the amount of real transactions in the economy and how much money is needed to facilitate these transactions. Additional supply of money is unlikely to make people consume more or work harder.

7. What is the effect of a foreign exchange intervention on the money supply? How can a central bank offset this effect and still hope to influence the exchange rate?

Answer:

When a central bank buys (sells) foreign currency, its international reserves increase (decrease), and the money supply increases (decreases) simultaneously. To offset the effect on the money supply, the foreign exchange intervention can be sterilized; that is, the central bank can perform an open market operation that counteracts the effect on the money supply of the original foreign exchange intervention. The direct effects of a sterilized intervention are two-fold. First, it forces a portfolio shift on private investors, by replacing foreign bonds with domestic bonds (or vice versa). This may affect expectations and prices. Second, the actions in the foreign exchange markets, while very small relative to the nominal trading volumes, may still manage to squeeze foreign exchange inventories at dealer banks and generate pricing effects. Indirectly, the central bank can signal its opinion on the fundamental value of the exchange rate through an intervention that consequently affects market expectations. There is no consensus on how effective sterilized interventions are in affecting the level and volatility of exchange rates.

Monash University Malaysia, BFW3331, S1 2014 3

BFW3331 Suggested answers for Tutorial 1 Week 2

8. How can a central bank peg the value of its currency relative to another currency?

Answer:To peg the value of its currency to another currency, the government must make a market in the two currencies involved. If there is excess supply of the foreign currency (which is equivalent to excess demand for the domestic currency) that would drive down the domestic currency price of the foreign currency, the government must buy the private excess supply of foreign currency and deliver domestic currency to those demanding it. On the contrary, if there is excess demand for foreign currency (which is equivalent to excess supply of domestic currency) that would drive up the domestic currency price of the foreign currency, the government must supply the foreign currency and demand the domestic currency to prevent the foreign currency from appreciating in value.

12. What are the potential benefits of a pegged currency system?

Answer:

Some believe that fixed exchange rate systems bring with it policy discipline and stability. A fixed exchange rate should discourage over-expansionary fiscal or monetary policies, which would cause inflation and a loss of competitiveness under a fixed exchange rate system. Hence, fixed exchange rates should induce the kind of policies that help control inflation. The absence of day-to-day exchange rate volatility in such a system should eliminate the uncertainty that comes with floating exchange rates and which might hamper international trade. Note that the argument that exchange rate volatility hampers international trade is far from generally accepted. For example, it ignores the possibility to hedge currency fluctuations. Moreover, pegged exchange rate systems are not without risks, and may show considerable “latent variability.” Such devaluation risk also complicates international trade.

Monash University Malaysia, BFW3331, S1 2014 4

BFW3331 Suggested answers for Tutorial 1 Week 2

15. How can central banks defend their currency—for example, if the currency is within a target zone or pegged at a particular value?

Answer: The monetary authorities in the countries with weaker currencies have three basic defense mechanisms available: (i) interventions, (ii) interest rate increases, and (iii) capital controls. Interventions to support the local currency may result (when not sterilized) in a lower money supply, reduced liquidity in the money market, and therefore higher interest rates. Central banks can also directly raise the interest rates they control (typically, the rate at which banks can borrow from the central bank), both to make currency speculation more costly and to signal commitment to the central rate. Finally, the authorities can limit foreign exchange transactions through capital controls, which may include taxes on (or outright prohibition of) the purchases of most foreign securities by the country’s residents.

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