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The interaction between international trade.
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- 2. EXCHANGE RATE SYSTEMS •Exchange rate systems can be classified in terms of the extent to which the exchange rates are government controlled. Exchange rate systems normally fall into one of the following categories, each of which will be discussed in turn: • Fixed, • Freely floating, • Managed float, or • Pegged.
- 3. Fixed Exchange RateSystem • In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries. A fixed exchange rate system requires cen- tral bank intervention in order to maintain a currency’s value within narrow boundaries. In general, the central bank must offset any imbalance between demand and supply con- ditions for its currency in order to prevent its value from changing. • In some situations, a central bank may reset a fixed exchange rate. That is, it will devalue or reduce the value of its currency against other currencies. A central bank’s actions to devalue a currency in a fixed exchange rate system are referred to as devaluation, whereas the term deprecia- tion refers to the decrease in a currency’s value that is allowed to fluctuate in response to market conditions.
- 4. • Thus, theterm depreciation is more commonly used when describing the decrease in values of currencies that are not subject to a fixed exchange rate system. In a fixed exchange rate system, a central bank may also revalue (increase the value of) its currency against other currencies. • Revaluation refers to an upward adjustment of the exchange rate by the central bank, whereas the term appreciation refers to the increase in a currency’s value that is allowed to fluctuate in response to market condi- tions. Like depreciation, appreciation is thus more commonly used when discussing currencies that are not subject to a fixed exchange rate system.
- 5. • Bretton WoodsAgreement (1944–1971) From 1944 to 1971, most exchange rates were fixed according to a system planned at the Bretton Woods conference (held in Bretton Woods, New Hampshire, in 1944) by representatives from various countries. Because this arrangement, known as the Bretton Woods Agreement, lasted from 1944 to 1971, that period is sometimes referred to as the Bretton Woods era. Each currency was valued in terms of gold; for example, the U.S. dollar was valued as 1/35 ounce of gold. Since all currencies were valued in terms of gold, their values with respect to each other were fixed. Governments intervened in the foreign exchange markets to ensure that exchange rates drifted no more than 1 percent above or below the initially set rates.
- 6. • Smithsonian Agreement,1971–1973: During the Bretton Woods era, the United States often experienced balance-of-trade deficits. These deficits indicated that the dollar may have been overvalued, since the use of dollars for foreign purchases exceeded the demand by foreign countries for dollar- denominated goods. By 1971, it appeared that some currency values would need to be adjusted in order to restore a more balanced flow of payments between countries. In December 1971, a conference of representatives from various countries concluded with the Smithsonian Agreement, which called for a devalu- ation of the U.S. dollar by about 8 percent against other currencies. In addition, boundaries for the currency values were expanded to within 2.25 percent above or below the rates ini- tially set by the agreement. Nevertheless, the imbalances in international payments contin- ued and, as of February 1973, the dollar was again devalued. By March 1973, most governments of the major countries were no longer attempting to maintain their home currency values within the boundaries established by the
- 7. Advantages of FixedExchange Rates • A fixed exchange rate would be beneficial to a country for several reasons. • First, exporters and importers could engage in interna- tional trade without concern about exchange rate movements of the currency to which their local currency is linked. Any firms that accept the foreign currency as payment would be insulated from the risk that the currency could depreciate over time. In addi- tion, any firms that need to obtain that foreign currency in the future would be insulated from the risk of the currency appreciating over time. • A second benefit is that firms could engage in direct foreign investment, without concern about exchange rate movements of that currency. They would be able to convert their foreign currency earnings into their home currency without concern that the foreign currency denominating their earnings might weaken over time. Thus, the management of an MNC would be much easier. • Third, investors would be able to invest funds in foreign countries without concern that the foreign currency denominating their investments might weaken over time. Funds are needed in any country to support economic growth. Countries that attract a large amount of capital flows normally have lower interest rates, which can stimulate their economies.
- 8. Disadvantages of FixedExchange Rates • One disadvantage of a fixed exchange rate system is that there is still a risk of the government altering its currency’s value. Although an MNC is not exposed to continual movements in an exchange rate, there is always the possibility that its home country’s central bank will devalue or revalue its own currency. • A second disadvantage is that, from a macro viewpoint, a fixed exchange rate system may render each country (and its MNCs) more vulnerable to economic conditions in other countries.
- 9. Managed Float ExchangeRate System • The exchange rate system that exists today for most currencies lies somewhere between fixed and freely floating. It resembles the freely floating system in that exchange rates are allowed to fluctuate on a daily basis and there are no official boundaries. It is similar to the fixed rate system in that governments can and sometimes do intervene to prevent their currencies from moving too far in a certain direction. This type of system is known as a managed float or “dirty” float (as opposed to a “clean” float where rates float freely without any government intervention).
- 10. Criticisms of theManaged Float System • Critics argue that the managed float system allows a government to manipulate exchange rates in order to benefit its own country at the expense of others. A government may attempt to weaken its currency to stimulate a stagnant economy. The increased aggregate demand for products that results from such a policy may cause a decreased aggregate demand for products in other countries, since the weakened currency attracts foreign demand. This is a valid criticism but could apply as well to the fixed exchange rate system, where governments have the power to devalue their currencies.
- 11. Pegged Exchange RateSystem • Some countries use a pegged exchange rate in which their home currency’s value is pegged to one foreign currency or to an index of currencies. Although the home currency’s value is fixed in terms of the foreign currency to which it is pegged, it moves in line with that currency against other currencies. • A government may peg its currency’s value to that of a stable currency, such as the dollar, because doing so stabilizes the value of its own currency. First, this forces the pegged currency’s exchange rate with the dollar to be fixed. Second, that currency will move against non-dollar currencies to the same extent as does the dollar. Because the dollar is more stable than most currencies, it will make the pegged currency more stable than most
- 12. Limitations of aPegged Exchange Rate • Although countries with a pegged exchange rate may attract foreign investment because the exchange rate is expected to remain stable, weak economic or political conditions can cause firms and investors to question whether the peg will hold. A country that suffers a sudden recession may experience capital outflows as some firms and investors withdraw funds because they believe other countries offer better investment opportunities. • These transactions result in an exchange of the local currency for dollars and other currencies, which puts downward pressure on the local currency’s value. The central bank would need to offset this pressure by intervening in the foreign exchange market (as explained shortly), but it might not be able to maintain the peg. If the peg is broken and if the exchange rate is dictated by market forces, then the local currency’s value could immediately decline by 20 percent or more.
- 13. Europe’s Snake Arrangement,1972–1979 • Several European countries established a pegged exchange rate arrangement in April 1972. Their goal was to maintain their currencies within established limits of each other. This arrangement became known as the snake. The snake was difficult to maintain, however, and market pressure caused some currencies to move outside their established limits. Consequently, some members withdrew from the snake arrangement and some currencies were realigned.
- 14. Exchange Rate Riskof a Pegged Currency • A currency that is pegged to another currency cannot be pegged against all other currencies. If a currency is pegged to the dollar, then it will move in tandem with the dollar against all other currencies.
- 15. Dollarization • Dollarization isthe replacement of a foreign currency with U.S. dollars. This process is a step beyond a currency board because it forces the local currency to be replaced by the U.S. dollar. • Although dollarization and a currency board both attempt to peg the local currency’s value, the currency board does not replace the local currency with dollars. The decision to use U.S. dollars as the local currency cannot be easily reversed because in that case the country no longer has a local currency.
- 16. GOVERNMENT INTERVENTION • Eachcountry has a central bank that may intervene in the foreign exchange markets to control its currency’s value. In the United States, for example, the central bank is the Federal Reserve System (the Fed). Central banks have other duties besides intervening in the foreign exchange market. In particular, they attempt to control the growth of the money supply in their respective countries in a way that will maintain economic growth and low inflation.
- 17. Reasons for GovernmentIntervention • The degree to which the home currency is controlled, or “managed,” varies among cen- tral banks. Central banks commonly manage exchange rates for three reasons: • To smooth exchange rate movements, • To establish implicit exchange rate boundaries, and • To respond to temporary disturbances.
- 18. Smoothing Exchange RateMovements • If a central bank is concerned that its economy will be affected by abrupt movements in the home currency’s value, then it may attempt to smooth (stabilize) those currency movements over time. These actions may render business cycles less volatile. Smoothing currency movements may also reduce fears in the financial markets as well as speculative activity that could cause a major decline in a currency’s value. So in reducing exchange rate uncertainty, the central bank hopes to encourage international trade.
- 19. Establishing Implicit ExchangeRate Boundaries • Some central banks attempt to maintain their home currency rates within some unofficial, or implicit, boundaries. Analysts are often quoted as forecasting that a currency will not fall below (or rise above) some benchmark value because the central bank would intervene to prevent that from occurring. In fact, the Federal Reserve periodically intervenes to reverse the U.S. dollar’s upward or downward momentum.
- 20. Responding to TemporaryDisturbances • In some cases, a central bank may intervene to insulate a currency’s value from a temporary disturbance. Note that the stated objective of the Fed’s intervention policy is to counter disorderly market conditions. • Several studies have found that government intervention does not have a permanent effect on exchange rate movements. To the contrary, in many cases the intervention is overwhelmed by market forces. In the absence of intervention, however, currency move- ments would be even more volatile.
- 21. Direct Intervention • Toforce the dollar to depreciate, the Fed can intervene directly by exchanging dollars that it holds as reserves for other foreign currencies in the foreign exchange market. By “flooding the market with dollars” in this manner, the Fed puts downward pressure on the dollar. If the Fed wants to strengthen the dollar then it can exchange foreign curren- cies for dollars in the foreign exchange market, thereby putting upward pressure on the dollar.
- 22. • Reliance onReserves: The potential effectiveness of a central bank’s direct intervention is influenced by the amount of reserves it can use. For example, the central bank of China has a substantial amount of reserves that it can use to intervene in the foreign exchange market. Thus, it can more effectively use direct intervention than many other Asian countries. If the central bank has a low level of reserves, it may not be able to exert much pressure on the currency’s value; in that case, market forces would likely overwhelm its actions.
- 23. • Frequency ofIntervention: As foreign exchange activity has grown, central bank intervention has become less effective. The volume of foreign exchange transactions on a single day now exceeds the combined values of reserves at all central banks. Conse- quently, the number of direct interventions has declined. In 1989, for example, the Fed intervened on 97 different days. Since then, the Fed has not intervened on more than 20 days in any year.
- 24. • Coordinated Intervention:Direct intervention is more likely to be effective when it is coordinated by several central banks. For example, if central banks agree that the euro’s market value in dollars is too high, then they can engage in coordinated interven- tion in which they all use euros from their reserves to purchase dollars in the foreign exchange market. • However, coordinated intervention requires the central banks to agree that a particular currency’s value needs to be adjusted. Suppose a few central banks thought the euro’s value was too high but that the ECB did not agree; in that case, the central banks would have to work out their differences before considering direct inter- vention in the foreign exchange market.
- 25. • Nonsterilized versusSterilized Intervention: When the Fed intervenes in the foreign exchange market without adjusting for the change in the money supply, it is engaging in a nonsterilized intervention. For example, if the Fed exchanges dollars for foreign currencies in the foreign exchange markets in an attempt to strengthen foreign currencies (weaken the dollar), the dollar money supply increases. • In a sterilized intervention, the Fed intervenes in the foreign exchange market and simultaneously engages in offsetting transactions in the Treasury securities markets. As a result, the dollar money supply is unchanged.
- 26. • Speculating onDirect Intervention: Some traders in the foreign exchange mar- ket attempt to determine when (and to what extent) the Federal Reserve will intervene so that they can capitalize on the anticipated results of the intervention effort. The Fed nor- mally attempts to intervene without being noticed. However, dealers at the major banks that trade with the Fed often transmit the information to other market participants. Also, when the Fed deals directly with numerous commercial banks, markets are well aware that the Fed is intervening. • To hide its strategy, the Fed may pretend to be interested in selling dollars when it is actually buying dollars, or vice versa. It calls commercial banks and obtains both bid and ask quotes on currencies; that way, the banks will not know whether the Fed is considering purchases or sales of these currencies.
- 27. Indirect Intervention • TheFed can also affect the dollar’s value indirectly by influencing the factors that determine it. Recall that the change in a currency’s spot rate is influenced by the following factors: e DINF, DINT, DINC, DGC, DEXP where • e: percentage change in the spot rate • DINF: change in the difference between U:S: inflation and the foreign country’s inflation • DINT: change in the difference between the U:S: interest rate and the foreign country’s interest rate • DINC: change in the difference between the U:S: income level and the foreign country’s income level • DGC: change in government controls • DEXP: change in expectations of future exchange rates
- 28. • The centralbank can influence all of these variables, which in turn can affect the exchange rate. Because these variables will probably have a more lasting impact on a spot rate than would direct intervention, a central bank may prefer to intervene indirectly by influencing these variables. Although the central bank can affect all of the variables, it is likely to focus on interest rates or government controls when using indirect intervention.
- 29. • Government Controlof Interest Rates: When central banks of countries increase or reduce interest rates, this may have an indirect effect on the values of their currencies. If the country experiences a currency crisis, then its central bank may raise interest rates in order to prevent a major flow of funds out of the country. • Government Use of Foreign Exchange Controls: Some governments attempt to use foreign exchange controls (such as restrictions on the exchange of the currency) as a form of indirect intervention to maintain the exchange rate of their currency. China has historically used foreign exchange restrictions to control the yuan’s exchange rate, but has partially removed these restrictions in recent years.
- 30. • Intervention Warnings:A central bank may announce that it is strongly considering intervention. Such announcements may be intended to warn speculators who are taking positions in a currency that benefit from appreciation in its value. An intervention warning could discourage additional speculation and might even encourage some speculators to unwind (liquidate) their existing positions in the currency. • In this case there would be a large supply of that currency for sale in the foreign exchange market, which would tend to reduce its value. Thus, the central bank might more effectively achieve its goal (to reduce the local currency’s value) with an intervention warning than with actual intervention.
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