Slide 1 of Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson.

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Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson

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Government Influence on Exchange Rates

Chapter 6Chapter 6

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Overview

Examine exchange rate systems Explain how governments intervene

to influence exchange rates Describe how intervention in

exchange market can affect economic conditions

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Why Do We need to know Government involvement

Internal National governments do things

which have a domestic effect on the value of their own currency

External Internationally, other governments do

things which can effect the value of your currency

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Internal By doing a bad job with inflation, or

unemployment a National governments can be seen to be not operating effectively, and this will create negative confidence among currency traders and international business people

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Internal By doing a bad job … the value of the

currency will decline If it declines it makes it very difficult

for consumers in that country to afford imported products

therefore standard of living will decline

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External Internationally, other governments do

things . . . By using trade barriers and import taxes

and other impediments which make it difficult for a country to export - this can deprive it of situations which can effect the value of its currency

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External If currency is pegged then it can go up

or down according to the rise and fall of the situation in another country

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Exchange Rate Systems

Classified according to the degree by government controls them

Fixed Freely floating Managed float Pegged

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Fixed– currency fluctuation limited to narrow

bands– Bretton Woods Agreement (1944-1971)

valued each currency in terms of gold permitted fluctuations of 1% from original

rates meant you also had to have gold on hand

– lessened currency risk for MNCs

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Freely floating exchange rates– market forces determine exchange rates– advantages

increases stability in global economy reduces maintenance of exchange rates by

central banks

– disadvantages may exacerbate a country’s economic

problems

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Managed Float exchange ratesManaged Float exchange rates– a mix of fixed and freely floating characteristicsa mix of fixed and freely floating characteristics– exchange rates fluctuate freely exchange rates fluctuate freely – government intervenes directly to manage the government intervenes directly to manage the

exchange rate exchange rate

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Pegged exchange ratesPegged exchange rates– ties a currency’s value to a foreign currency or ties a currency’s value to a foreign currency or

to some unit of accountto some unit of account examples include European Economic Community examples include European Economic Community

and the European Currency Unitand the European Currency Unit

– produces dependency upon the movement of produces dependency upon the movement of the foreign currencythe foreign currency

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Potential barriers to a single European Potential barriers to a single European currencycurrency– meeting specified economic targetsmeeting specified economic targets– impact of monetary policyimpact of monetary policy

consolidation of European monetary policyconsolidation of European monetary policy

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Government Intervention

Reasons for interventionReasons for intervention– smoothing exchange ratessmoothing exchange rates– establishing implicit exchange rate boundariesestablishing implicit exchange rate boundaries– responding to temporary disturbancesresponding to temporary disturbances

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Government InterventionDirect Intervention

Central bank actively trades on exchange Central bank actively trades on exchange market to influence currency valuesmarket to influence currency values– attempt to weaken home currencyattempt to weaken home currency

trade home currency for foreign currencytrade home currency for foreign currency– places downward pressure on home currencyplaces downward pressure on home currency

– attempt to strengthen home currencyattempt to strengthen home currency exchange foreign currency for home currencyexchange foreign currency for home currency

– places upward pressure on home currencyplaces upward pressure on home currency

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Nonsterilized interventionNonsterilized intervention– intervention in exchange market without intervention in exchange market without

adjusting for the change in money supplyadjusting for the change in money supply money supply increases with attempts to weaken money supply increases with attempts to weaken

home currencyhome currency money supply decreases with attempts to strengthen money supply decreases with attempts to strengthen

home currencyhome currency

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Sterilized interventionSterilized intervention– intervention in exchange market while making intervention in exchange market while making

adjustments to avoid change in money supplyadjustments to avoid change in money supply transact simultaneously in exchange markets and transact simultaneously in exchange markets and

Treasury securities marketsTreasury securities markets

– strengthen home currency by:strengthen home currency by: 1) exchange home currency for foreign currency1) exchange home currency for foreign currency 2) sell holdings of Treasury securities for home 2) sell holdings of Treasury securities for home

currencycurrency

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Government InterventionIndirect Intervention

Central banks affect currency values by Central banks affect currency values by influencing factors that determine exchange influencing factors that determine exchange ratesrates– increase or decrease money supply to move increase or decrease money supply to move

interest rates in desired directioninterest rates in desired direction

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Exchange Rate Target Zones

Proposed to reduce volatility in exchange Proposed to reduce volatility in exchange rates of major currenciesrates of major currencies– suggest creating a central rate with specific suggest creating a central rate with specific

boundariesboundaries– governments would be responsible for governments would be responsible for

maintaining currencies within the zonesmaintaining currencies within the zones– Louvre Accord established acceptable rangesLouvre Accord established acceptable ranges

US intervention quickly declined over timeUS intervention quickly declined over time

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Intervention as a Policy Tool

Impact of weak currency on economyImpact of weak currency on economy– may stimulate foreign demand for productsmay stimulate foreign demand for products– may reduce importsmay reduce imports– may boost exports and jobsmay boost exports and jobs

Impact of strong currency on economyImpact of strong currency on economy– encourages greater demand for importsencourages greater demand for imports– constrains price increases through competitionconstrains price increases through competition

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Summary

Exchange rate systems:Exchange rate systems:– fixed rate, freely floating, managed and peggedfixed rate, freely floating, managed and pegged

Direct intervention Direct intervention – buy or sell currencies on exchange marketbuy or sell currencies on exchange market

Indirect interventionIndirect intervention– influence economic factors that affect exchange influence economic factors that affect exchange

ratesrates

Slide 1 of Slides developed by Jeff Madura, with additions and enhancements by Tim Richardson.

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