ICF11e ch06

International Financial Management
12th Edition
by Jeff Madura
1 © 2012 Cengage Learning. All Rights Reserved. May not be copied, scanned, or duplicated, in whole or in part, except for use as
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Part 2 Exchange Rate Behavior
Government Influence on Exchange
6 Rates
Chapter Objectives
 Describe the exchange rate system used by various

governments
 Describe the development and implications of a single

European currency
 Explain how governments can use direct intervention to

influence exchange rates
 Explain how government intervention in the foreign

exchange market can affect economic conditions
3
Exchange Rate Systems
Exchange rate systems can be classified

according to the degree of government control
and fall into the following categories:
 Fixed
 Freely floating
 Managed float
 Pegged
Fixed Exchange Rate System
1. Exchange rates are either held constant or allowed to

fluctuate only within very narrow boundaries.
2. Central bank can reset a fixed exchange rate by
devaluing or reducing the value of the currency
against other currencies.
3. Central bank can also revalue or increase the value of
its currency against other currencies.
Fixed Exchange Rate System
 Examples:
 Bretton Woods Agreement 1944 – 1971 - Each currency was
valued in terms of gold.
 Smithsonian Agreement 1971 – 1973 - called for a
devaluation of the U.S. dollar by about 8 percent against
other currencies.
 Advantages of fixed exchange rate system
 Insulate country from risk of currency appreciation.
 Allow firms to engage in direct foreign investment without
currency risk.
 Disadvantages of fixed exchange rate system
 Risk that government will alter value of currency.
 Country and MNC may be more vulnerable to economic
conditions in other countries.
Freely Floating Exchange Rate System
 Exchange rates are determined by market forces

without government intervention.
 Advantages of freely floating system:
 Country is more insulated from inflation of other countries.
 Country is more insulated from unemployment of other
countries.
 Does not require central bank to maintain exchange rates
within specified boundaries.
 Disadvantages of freely floating system:
 Can adversely affect a country that has high unemployment.
 Can adversely affect a country with high inflation.
Managed Float Exchange Rate System
 Governments sometimes intervene to prevent their

currencies from moving too far in a certain direction.
 Critics suggest that managed float allows a
government to manipulate exchange rates to benefit
its own country at the expense of others.
 Currencies of most large developed countries are
allowed to float, although they may be periodically
managed by their respective central banks.
Exhibit 6.1 Exchange Rate Arrangements
Pegged Exchange Rate System
 Home currency value is pegged to one foreign

currency or to an index of currencies.
 May attract foreign investment because exchange rate
is expected to remain stable.
 Weak economic or political conditions can cause
firms and investors to question whether the peg will
be broken.
Pegged Exchange Rate Systems
Examples:
Europe’s Snake Arrangement 1972 – 1979
European Monetary System (EMS) 1979 – 1992
Mexico’s Pegged System 1994
China’s Pegged Exchange Rate 1996 – 2005
Venezuela’s Pegged Exchange Rate 2010
Pegged Exchange Rate Systems (Cont.)
 Currency Boards Used to Peg Currency Values - a

system for pegging the value of the local currency to some
other specified currency. The board must maintain
currency reserves for all the currency that it has printed.
 Interest Rates of Pegged Currencies - Interest rate will
move in tandem with the interest rate of the currency to
which it is tied.
 Exchange Rate Risk of a Pegged Currency – (Exhibit
6.2) provides examples of countries that have pegged the
exchange rate of their currency to a specific currency.
Currencies are commonly pegged to the U.S. dollar or to
the euro.
Exhibit 6.2 Pegged Exchange Rates
Dollarization
 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.
A Single European Currency
 Monetary Policy in the Eurozone

 European Central Bank - based in Frankfurt and is responsible for
setting monetary policy for all participating European countries
 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.
 Impact on Firms in the Eurozone - Prices of products are now
more comparable among European countries.
 Impact on Financial Flows in the Eurozone - Bond investors
who reside in the eurozone can now invest in bonds issued by
governments and corporations in these countries without concern about
exchange rate risk, as long as the bonds are denominated in euros.
A Single European Currency
 Exposure of Countries within the Eurozone

 A single European monetary policy prevents any individual
European country from solving local economic problems with its
own unique monetary policy.
 Any given monetary policy used in the eurozone during a particular
period may enhance conditions in some countries and adversely
affect others.
 Impact of Crises within the Eurozone - may affect the economic
conditions of the other participating countries because they all rely on
the same currency and same monetary policy.
Reasons for Government Intervention
1. Smooth exchange rate movements

If a central bank is concerned that its economy will be affected
by abrupt movements in its home currency’s value, it may
attempt to smooth the currency movements over time.
2. Establish implicit exchange rate boundaries
Some central banks attempt to maintain their home currency
rates within some unofficial, or implicit, boundaries.
3. Respond to temporary disturbances
A central bank may intervene to insulate a currency’s value from
a temporary disturbance.
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 desires to strengthen the dollar, it can exchange

foreign currencies for dollars in the foreign exchange
market, thereby putting upward pressure on the dollar.
Exhibit 6.3 Effects of Direct Central Bank
Intervention in the Foreign Exchange Market
Direct Intervention
 Reliance on reserves
The potential effectiveness of a central bank’s direct intervention is the
amount of reserves it can use.
 Nonsterilized versus sterilized intervention (See Exhibit 6.4)
 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.
 In a sterilized intervention, the Fed intervenes in the foreign
exchange market and simultaneously engages in offsetting
transactions in the Treasury securities markets.
 Speculating on direct intervention
Some traders in the foreign exchange market attempt to determine when
Federal Reserve intervention is occurring and the extent of the
intervention in order to capitalize on the anticipated results of the
intervention effort.
Exhibit 6.4 Forms of Central Bank Intervention
in the Foreign Exchange Market
Indirect Intervention
The Fed can affect the dollar’s value indirectly by influencing the factors that
determine it.
e  f (INF , INT , INC , GC, EXP)
where
e  percentage change in the spot rate
INF  change in the differenti al between U.S. inflation
and the foreign country' s inflation
INT  change in the differenti al between th e U.S. interest rate
and the foreign country' s interest rate
INC  change in the differenti al between th e U.S. income level
and the foreign country' s income level
GC  change in government controls
EXP  change in expectatio ns of future exchange rates
Indirect Intervention
Government Control of Interest Rates by increasing

or reducing interest rates
Foreign Exchange Controls such as restrictions on
the exchange of the currency
Intervention Warnings intended to warn speculators.
The announcements could discourage additional
speculation and might even encourage some
speculators to unwind (liquidate) their existing
positions in the currency.
Intervention as a Policy Tool
1. A weak home currency can stimulate foreign demand

for products. (See Exhibit 6.5)
2. A strong home currency can encourage consumers
and corporations of that country to buy goods from
other countries. (See Exhibit 6.6)
Exhibit 6.5 How Central Bank Intervention Can
Stimulate the U.S. Economy
Exhibit 6.6 How Central Bank Intervention Can Reduce
Inflation
SUMMARY
 Exchange rate systems can be classified as fixed rate, freely

floating, managed float, and pegged. In a fixed exchange rate
system, exchange rates are either held constant or allowed to
fluctuate only within very narrow boundaries. In a freely
floating exchange rate system, exchange rate values are
determined by market forces without intervention. In a
managed float system, exchange rates are not restricted by
boundaries but are subject to government intervention. In a
pegged exchange rate system, a currency’s value is pegged to
a foreign currency or a unit of account and moves in line with
that currency (or unit of account) against other currencies.
SUMMARY (Cont.)
 Numerous European countries use the euro as their home

currency. The single currency allows international trade by
firms within the eurozone without foreign exchange expenses
and without concerns about future exchange rate movements.
However, countries that participate in the euro do not have
complete control of their monetary policy because one
monetary policy is applied to all countries in the eurozone. In
addition, some countries might be more susceptible to a crisis
in another country in the eurozone as a result of being in the
eurozone.
SUMMARY (Cont.)
 Governments can use direct intervention by purchasing or

selling currencies in the foreign exchange market, thereby
affecting demand and supply conditions and, in turn,
affecting the equilibrium values of the currencies. When a
government purchases a currency in the foreign exchange
market, it puts upward pressure on the currency’s equilibrium
value. When a government sells a currency in the foreign
exchange market, it puts downward pressure on the
currency’s equilibrium value. Governments can use indirect
intervention by influencing the economic factors that affect
equilibrium exchange rates.
SUMMARY (Cont.)
 When government intervention is used to weaken the U.S.

dollar, the weak dollar can stimulate the U.S. economy by
reducing the U.S. demand for imports and increasing the
foreign demand for U.S. exports. Thus, the weak dollar tends
to reduce U.S. unemployment, but it can increase U.S.
inflation. When government intervention is used to
strengthen the U.S. dollar, the strong dollar can increase the
U.S. demand for imports, thereby intensifying foreign
competition. The strong dollar can reduce U.S. inflation but
may cause a higher level of U.S. unemployment.

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International Financial Management

 Describe the exchange rate system used by various

 Describe the development and implications of a single

 Explain how governments can use direct intervention to

 Explain how government intervention in the foreign

Exchange rate systems can be classified

1. Exchange rates are either held constant or allowed to

 Exchange rates are determined by market forces

 Governments sometimes intervene to prevent their

 Home currency value is pegged to one foreign

 Currency Boards Used to Peg Currency Values - a

 Replacement of a foreign currency with U.S.

 Monetary Policy in the Eurozone

 Exposure of Countries within the Eurozone

1. Smooth exchange rate movements

To force the dollar to depreciate, the Fed can intervene

By “flooding the market with dollars” in this manner, the

If the Fed desires to strengthen the dollar, it can exchange

e  f (INF , INT , INC , GC, EXP)

Government Control of Interest Rates by increasing

1. A weak home currency can stimulate foreign demand

 Exchange rate systems can be classified as fixed rate, freely

 Numerous European countries use the euro as their home

 Governments can use direct intervention by purchasing or

 When government intervention is used to weaken the U.S.

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