FIN4604 EXAM 2 Chapters 6 7 8 Chapter 6 Government Influence on Exchange Rates Exchange Rate Systems Classified according to the degree to which rates are government controlled Fixed Exchange Rate System Rates are fixed against a value and held constant or allowed to fluctuate within very narrow bands only o Benefits MNCs know the future exchange rates they actually know how much they ll receive in the future or how much they ll have to pay o Disadvantage Government can revalue their currencies Each country is also sensitive to the economic conditions in other countries If any country devalues their currency it s at the expense of other countries o Keeping the value of a currency fixed is unnatural Freely Floating Exchange Rate System Rates are determined by market forces without government intervention o Most popular for developed countries and huge economies i e the U S o Benefits Each country is more insulated shielded from other countries economic problems Central bank is allowed to keep its focus on inflation and their intervention is not needed to control exchange rates Governments are not constrained by need to maintain exchange rates when setting new policies because they don t control exchange rates the market does i e if need to increase interest rates because inflation is increasing they aren t constrained by how increasing interest rates will increase the value of the currency Less capital flow restrictions are needed enhances market efficiency o Disadvantages rate fluctuations compounded May need to devote substantial resources to manage their exposure to exchange The country that initially experienced economic problems may have its problems Problems are worsened i e truckers pay for own gas out of salary they wanted the dollar to be propped up so gas would be cheaper Managed Float Exchange Rate System Exchange rates are allowed to move freely on a daily basis and no official boundaries exist but governments may intervene if they need to prevent the rates from moving too much in a certain direction o it s floated normally but when things get bad the government steps in o more likely that government will step in when currency is too strong what Japan did big portion of their GDP is exports when their exports are depressed it hurts their GDP badly o Disadvantage expense of other countries A government may manipulate its exchange rates such that its own country benefits at the Pegged Exchange Rate System the currency s value is pegged to a foreign currency or to some unit of account and moves in line with that currency unit against other currencies it is fixed to a currency that is moving around o i e pegged against the Dollar then once the Dollar becomes stronger compared to the Yen so will this currency the is the most popular currency to be pegged against by other currencies o Currency Boards system for pegging the value of the local currency to some other specified currency Benefit Can stabilize currency s value economy Disadvantages Only effective if investors believe it will last a lot of times not sustainable Local interest rates must align with interest rates of the currency to which the local currency is tied may include a risk premium Currency that is pegged to another currency will have to move in tandem with that currency against all other currencies o Dollarization the replacement of a foreign currency with U S dollars extreme version of pegging taking it one step further to stabilize the economy goes beyond currency board since the country no longer has a local currency Chinese Currency Pegged to the U S dollar Yuan was devalued to increase competitiveness of China s exports The Yuan is currently allowed to float but within narrow margins around fixed rate Chinese government suggests that they will let currency completely float eventually China 2nd largest economy and should be 1st in the next 5 years Not normal that they peg their currency since they re such a large economy China let their currency appreciate by 2 5 after the U S China Disagreement but depreciated it post Financial Crisis A Single European Currency The 1991 Maastricht Treaty the creation of the euro called for a single European currency European Union collection of countries that agree to standardization of regulations o 28 members Eurozone countries that gave up their currency to take on the euro o 19 members o European Central Bank ECB setting European monetary policy setting interest rates for their currency consolidated because of the single money supply euro o Each participating country can still rely on its own fiscal policy tax and government spending decisions to help solve its local economic problems o No exchange rate risk because they all have the same currency o No foreign exchange transaction cost don t need forward future contracts options o More comparable product pricing more cross border trade and capital flows o Easier to conduct and compare valuations of firms across the participating European countries because based on same currency value o Interest rates offered on government securities will have to be similar across the participating European countries o Stock and bond prices will be more comparable more cross border investing o But non European investors may not achieve as much diversification as in the past i e investing in Germany and Japan vs investing in Germany and France Government Intervention Each country has a central bank o It may intervene in the foreign exchange market to control its currency s value o It may attempt to control the money supply growth in its country o US s central bank the Fed o Central Banks manage exchange rates To smooth exchange rate movements To establish implicit exchange rate boundaries To respond to temporary disturbances o Intervention is often overwhelmed by market forces but currency value may move more if there is no government intervention at all o However this doesn t occur in the US Fed s job is to keep their eye on inflation not exchange rates Direct intervention the exchange of currencies that the central bank holds as reserves for other currencies in the foreign exchange market going in the market and trading currency buy to push value up and sell to push value down China sells to push value down China also has the most amount of dollars in their reserve in the world o Most effective when there is a coordinated effort among central banks when central banks have high levels of reserves to use o Effects of Direct