Chapter 6: Government Influence On Exchange Rate Exchange Rate System Fixed Exchange Rate System

CHAPTER 6 : GOVERNMENT INFLUENCE ON EXCHANGE RATE
EXCHANGE RATE SYSTEM
Fixed Exchange Rate System
Fixed Exchange Rate system is an exchange rate that allowed to fluctuate within very
narrow boundaries. A fixed exchange rate system requires central 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 conditions for its currency in order to
prevent its value from changing.
Freely Floating Exchange Rate System
In a freely floating exchange rate system, exchange rate values are determined by
market forces without intervention by governments. Whereas a fixed exchange rate system
allows only limited exchange rate movements, a freely floating exchange rate system allows
for complete flexibility. A freely floating exchange rate adjusts on a continual basis in
response to the demand and supply conditions for that currency.
Managed Floating Exchange Rate 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). The various forms of intervention used by governments to
manage exchange rate movements are discussed later in this chapter.
Pegged Exchange Rate System
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.
Dollarization
Dollarization is the 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.
A SINGLE EUROPEAN CURRENCY

Monetary Policy in Eurozone
The adoption of the euro subjects all participating countries to the same monetary
policy. The European Central Bank (ECB) is based in Frankfurt and is responsible for setting
monetary policy for all participating European countries. Its objective is to control inflation in
the participating countries and to stabilize (within reasonable boundaries) the value of the
euro with respect to other major currencies. Thus, the ECB’s monetary goals of price stability
and currency stability are similar to those of central banks in many other countries around the
world, with the difference that these goals concern a group of countries rather than a single
country. It could be argued that a set of countries with the same currency and monetary
policy will achieve greater economic stability than if each of these countries had its own
currency and monetary policy.
Impact of Firms in Eurozone
Firms in the eurozone may face more pressure to perform well because they can be
measured against all other firms in the same industry throughout the participating countries,
not just within their own country. Therefore, these firms are typically more focused on
meeting various performance goals.
Impact on Financial Flows in The Eurozone
A single European currency forces the interest rate offered on government securities
to be similar across the participating European countries. Any discrepancy in rates would
encourage investors within these countries to invest in the currency with the highest rate,
which would realign the interest rates among them. However, the rate may still vary between
two government securities with the same maturity if they exhibit different levels of credit
risk.
Exposure of Countries within the Eurozone
It may be argued that a single currency and monetary policy among many countries
can create more stable economic conditions because the system is larger and thus may be less
susceptible to outside shocks. However, a single European monetary policy prevents any
individual European country from solving local economic problems with its own unique
policy. Any monetary policy used in the eurozone during a particular period may enhance
conditions in some countries while adversely affecting conditions in other countries.
Impact of Crises within the Eurozone
One argument for the adoption of the euro is that the economies of the participating
countries will become more integrated, which means that favorable conditions in some
eurozone countries will be transmitted to the other participating countries. However, the same
rationale suggests that unfavorable conditions could likewise be transmitted. When a country
within the eurozone experiences a crisis, it may affect the economic conditions of the other
participating countries because they all rely on the same currency and same monetary policy.
Impact on a Country That Abandons the Euro
A eurozone country that is experiencing budget deficit problems does not have direct control
of the currency’s value, since there are many other countries that participate in the euro. If the
country had its own currency then it might be able to set its exchange rate low enough that its
currency (and hence its exports) become inexpensive to potential importers, which would
help stimulate the economy. However, a weak home currency is not a perfect cure because it
can cause higher inflation.
Impact of Abandoning the Euro on Eurozone Conditions
In general, countries can more easily attract foreign investment from MNCs and large
institutional investors when their local currency is expected to be stable. When the euro was
created, the large number of participants in the eurozone probably reduced concerns about
currency instability and so attracted more foreign investment in eurozone countries than if
each had their own local currency. Yet because there has been a substantial amount of foreign
investment in the eurozone, any concerns about the euro can now cause a much greater flow
of funds out of Europe in the event that MNCs and institutional investors decide to withdraw
their investments.
GOVERNMENT INTERVENTION
Reasons for Government Intervention
The degree to which the home currency is controlled, or “managed,” varies among
central 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.
Direct Intervention
To force 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 currencies for
dollars in the foreign exchange market, thereby putting upward pressure on the dollar.
Indirect Intervention
The Fed 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 ¼ f ðDINF, DINT, DINC, DGC, DEXPÞ
where
e ¼ percentage change in the spot rate
DINF ¼ change in the difference between U:S: inflation and the foreign country’s inflation
DINT ¼ change in the difference between the U:S: interest rate and the foreign country’s
interest rate
DINC ¼ change in the difference between the U:S: income level and the foreign country’s
income level
DGC ¼ change in government controls
DEXP ¼ change in expectations of future exchange rates
The central bank 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.
INTERVENTION AS A POLICY TOOL
Influence of a Weak Home Currency
A weak home currency can stimulate foreign demand for products. A weak dollar, for
example, can substantially boost U.S. exports and U.S. jobs; in addition, it may also reduce
U.S. imports. Exhibit 6.5 shows how the Federal Reserve can use either direct or indirect
intervention to affect the value of the dollar in order to stimulate the U.S. economy. When the
Fed reduces interest rates as a form of indirect intervention, it may stimulate the U.S.
economy by reducing not only the dollar’s value but also the financing costs of firms and
individuals in the United States.
Influence of a Strong Home Currency
A strong home currency can encourage consumers and corporations of that country to
buy goods from other countries. This situation intensifies foreign competition and forces
domestic producers to refrain from increasing prices. Therefore, the country’s overall
inflation rate should be lower if its currency is stronger, other things being equal.

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Chapter 6: Government Influence On Exchange Rate Exchange Rate System Fixed Exchange Rate System

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CHAPTER 6 : GOVERNMENT INFLUENCE ON EXCHANGE RATE

EXCHANGE RATE SYSTEM

Fixed Exchange Rate System

Freely Floating Exchange Rate System

A SINGLE EUROPEAN CURRENCY

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