28. Pegged Exchange Rates. The U.S., Argentina, and Canada commonly engage in international trade
with each other. All the products traded can easily be produced in all three countries. The traded
products are always invoiced in the exporting country’s currency. Assume that Argentina decides to
peg its currency (called the peso) to the U.S. dollar and the exchange rate will remain fixed. Assume
that the Canadian dollar appreciates substantially against the U.S. dollar during the next year.
a. What is the likely effect (if any) of the Canadian dollar’s exchange rate movement over the year
on the volume of Argentina’s exports to Canada? Briefly explain.
b. What is the likely effect (if any) of the Canadian dollar’s exchange rate movement on the volume
of Argentina’s exports to the U.S.? Briefly explain.
ANSWER:
a. The Canadian dollar appreciates against the U.S. dollar, so this means that the Canadian dollar will
b. The U.S should demand more from Argentina because imports are now cheaper there as compared
29. Central Bank Control Over Its Currency’s Value. Assume that France wants to change the
prevailing spot rate of its currency (euro) in order to improve its economy, while Switzerland wants to
change the prevailing value of its currency (Swiss franc) in order to improve its economy. Which of
these two countries is more likely to have more control over its currency? Briefly explain.
ANSWER: Switzerland should have more control over its currency. France does not have control
30. Coordinated Central Bank Intervention. Assume that the U.S. has a weak economy and that the
Fed wants to correct this problem by adjusting the value of the dollar. The Fed is not worried about
inflation. Assume that the Eurozone has a somewhat similar economic situation as the U.S. and the
European Central Bank (ECB) wants to correct this problem by adjusting the value of the euro. The
ECB is not worried about inflation. Do you think the European Central Bank and the Fed should
engage in coordinated intervention in order to achieve their objectives? Briefly explain.
ANSWER: Coordinated intervention occurs when central banks agree to use similar direct
intervention to push a specific currency’s value in one direction. However, in this example, each
31. Effects of Central Bank Intervention. a. Assume that the Federal Reserve engages in intervention
by exchanging a very large amount of Canadian dollars for U.S. dollars in the foreign exchange
market.
a. Should this increase, reduce, or have no effect on Canadian inflation? Briefly explain.
b. Ignore the actions of the Federal Reserve in the question above and assume that the Canadian
central bank raises its interest rates. Should this increase, reduce, or have no effect on Canadian
inflation? Briefly explain.
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Government Influence on Exchange Rates 2
c. The Hong Kong dollar is tied to the U.S. dollar and will continue to be tied to the dollar. Given
your answer in part (a), how will the intervention by the Federal Reserve affect the cross exchange
rate between the Canadian dollar and the Hong Kong dollar?
ANSWER:
a. It should weaken the Canadian dollar, which should stimulate Canada’s economy, but that also
32. Role of the ECB.
a. Explain the dilemma that the European Central Bank (ECB) faces as it attempts to help countries
with large budget deficits.
b. Describe the types of conditions that the ECB required when providing credit to countries that
needed to resolve their budget deficit problems.
c. Why might these conditions have a temporary adverse effect on countries that receive credit from
the ECB?
ANSWER:
a. The ECB faces a dilemma when providing credit. If it freely provides credit to any country whose
b. When the ECB provides credit to a country, it imposes restrictions that are intended to help the
c. Austerity conditions could weaken the country’s economy further, because less spending by the
33. Impact of Abandoning the Euro
a. Explain why one country abandoning the euro could reduce the value of the euro, even if that
country accounts for a very small proportion of the total production among all Eurozone participants.
b. Explain why one country abandoning the euro could affect the value of the assets in the Eurozone,
even if that country accounts for a very small proportion of the total production among all Eurozone
participants.
ANSWER:
a. If one country abandoned use of the euro, it might signal the possible abandonment by other
countries that presently participate in the euro. If MNCs and large institutional investors outside of
b. The sales of assets in the Eurozone in order to move money out of the euro could cause a reduction
in the valuations of these assets (even when ignoring the currency effect). Fear of these conditions
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Government Influence on Exchange Rates 3
Solution to Continuing Case Problem: Blades, Inc.
1. Did the intervention effort by the Thai government constitute direct or indirect intervention? Explain.
ANSWER: The intervention effort by the Thai government constituted direct intervention, since the
government exchanged dollar reserves for baht in order to strengthen the currency. This action would
2. Did the intervention by the Thai government constitute sterilized or nonsterilized intervention? What
is the difference between the two types of intervention? Which type do you think would be more
effective in increasing the value of the baht? Why? (Hint: Think about the effect of nonsterilized
intervention on U.S. interest rates.)
ANSWER: The intervention by the Thai government constituted nonsterilized intervention.
Using nonsterilized intervention, a central bank intervenes in the foreign exchange market without
An increase in the money supply may decrease U.S. interest rates, which may additionally weaken the
3. If the Thai baht is virtually fixed with respect to the dollar, how could this affect U.S. levels of
inflation? Do you think these effects on the U.S. economy will be more pronounced for companies
such as Blades that operate under trade arrangements involving commitments or for firms that do not?
How are companies such as Blades affected by a fixed exchange rate?
ANSWER: Under a fixed exchange rate system, inflation may be exported from one country to
For companies such as Blades, this effect would probably be more pronounced as their cost of
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Government Influence on Exchange Rates 4
4. What are some of the potential disadvantages for Thai levels of inflation associated with the floating
exchange rate system that is now used in Thailand? Do you think Blades contributes to these
disadvantages to a great extent? How are companies such as Blades affected by a freely floating
exchange rate?
ANSWER: A freely floating exchange rate may compound Thailand’s inflationary problems. For
example, if Thailand experiences high levels of inflation, the baht may weaken. In turn, a weaker baht
Blades does not contribute to these problems, as both its exports and imports are denominated in baht.
Blades could still be affected by a freely floating exchange rate system, as it is now subject to
5. What do you think will happen to the Thai baht’s value when the swap arrangement is completed?
How will this affect Blades?
ANSWER: Under the terms of the agreement, completion of the swap arrangement requires Thailand
to reverse the swap of its baht reserves for dollars. Specifically, it will have to exchange dollars for
Since Blades has net inflows in baht, it will be negatively affected by the completion of the swap
Solution to Supplemental Case: Hull Importing Company
a. Higher interest rates without an increase in inflation would adversely affect Hull, because its
expenses would increase, but it would not be able to pass on the higher cost to customers.
b. If the British pound’s value is increased, Hull’s expenses are increased, causing an adverse effect.
Small Business Dilemma
Assessment of Central Bank Intervention by the Sports Exports Company
1. Forecast whether the British pound will weaken or strengthen based on the information provided.
ANSWER: If the Bank of England floods the foreign exchange market with pounds, there will be
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Government Influence on Exchange Rates 5
2. How would the performance of the Sports Exports Company be affected by the Bank of England’s
policy of flooding the foreign exchange market with British pounds (assuming that it does not hedge
its exchange rate risk)?
ANSWER: The performance of the Sports Exports Company would be adversely affected by the
ANSWERS TO APPENDIX DISCUSSION QUESTIONS
1. Was the depreciation of the Asian currencies during the Asian crisis due to trade flows or capital
flows? Why do think the degree of movement over a short period may depend on whether the reason
is trade flows or capital flows?
ANSWER: The depreciation of the Asian currencies during the Asian crisis is mostly attributed to the
2. Why do you think the Indonesia rupiah was more exposed to an abrupt decline in value than the
Japanese yen during the Asian crisis (even if their economies experienced the same degree of
weakness)?
ANSWER: Investors knew that Indonesia was attempting to use intervention to prevent the rupiah
3. During the Asian crisis, direct intervention did not prevent depreciation of currencies. Offer your
explanation for why the interventions did not work.
ANSWER: Direct intervention can be overwhelmed by market forces, especially when investors are
4. During the Asian crisis, some of the local firms in Asia borrowed dollars rather than local currency to
support local operations. Why would they borrow dollars when they really needed their local currency
to support operations? Why did this strategy backfire?
ANSWER: They could obtain dollars at a lower interest rate. This strategy backfired because the
5. The Asian crisis showed that a currency crisis could affect interest rates. Why did the crisis put
upward pressure on interest rates in Asian countries? Why did it put downward pressure on U.S.
interest rates?
ANSWER: The crisis put upward pressure on interest rates because the central banks of these
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Government Influence on Exchange Rates 6
6. It is commonly argued that high interest rates reflect the expectation of high inflation. Based on this
theory, how would expectations of Asian exchange rates change after interest rates in Asia increased?
Why? Is the underlying reason logical?
ANSWER: Higher Asian interest rates could result in weaker Asian currencies, because the high
7. During the Asian crisis, why did the discount of the forward rate of Asian currencies change? Do you
think it increased or decreased? Why?
ANSWER: The discount on the forward rate became more pronounced as the Asian interest rates
8. During the Hong Kong crisis, the Hong Kong stock market declined substantially over a four-day
period due to concerns in the foreign exchange market. Why would stock prices decline due to
concerns in the foreign exchange market? Why would some countries be more susceptible to this type
of situation than others?
ANSWER: The Hong Kong dollar is tied to the U.S. dollar. Yet, if the fixed rate is broken because of
9. On August 26, 1998, the day that Russia decided to let the ruble float freely, the ruble declined by
about 50 percent. N the following day, called bloody Thursday, stock markets around the world
(including the U.S.) declined by more than 4 percent. Why do you think the decline in the ruble had
such a global impact on stock prices? Was the market’s reaction rational? Would the effect have been
different if the ruble’s plunge had occurred in an earlier time period, such as four years earlier?
ANSWER: The decline in the ruble caused general paranoia about a crisis that could be transmitted to
other countries. For example, a 50 percent decline in the value of the ruble means that Russian firms
may be unable to repay debts denominated in the dollar or other currencies. This could create
problems for lenders in those countries, which could result in weak economies. The market reaction
to the ruble’s plunge was probably more pronounced because it occurred during the Asian crisis when
the level of paranoia was already high.
10. Normally, a weak local currency is expected to stimulate the local economy. Yet, it appeared that the
weak currencies of Asia adversely affected their economies. Why do you think the weakening of the
currencies did not initially improve the economies during the Asian crisis?
ANSWER: The weak Asian currencies caused concerns that the firms that borrowed foreign
currencies would not be able to repay their debts. In addition, investors expected that the currencies
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Government Influence on Exchange Rates 7
11. During the Asian crisis, Hong Kong and China successfully intervened (by raising their interest rates)
to protect their local currencies from depreciating. Nevertheless, these countries were also adversely
affected by the Asian crisis. Why do you think the actions to protect the values of their currencies
affected these countries’ economies? Why do you think the weakness of other Asian currencies
against the dollar and the stability of the Chinese and Hong Kong currencies against the dollar
adversely affected their economies?
ANSWER: Since the currencies of China and Hong Kong were tied to the dollar, they appreciated
12. Why do you think the values of bonds issued by Asian governments declined during the Asian crisis?
Why do you think the values of Latin American bonds declined in response to the Asian crisis?
ANSWER: Asian bond prices are influenced by the required rate of return, which is influenced by the
13. Why do you think the depreciation of the Asian currencies adversely affected U.S. firms? (There are
at least three reasons, each related to a different type of exposure of some U.S. firms to exchange rate
risk.)
ANSWER: U.S. firms were adversely affected because their products became more expensive to
14. During the Asian crisis, the currencies of many Asian countries declined even though their
governments attempted to intervene with direct intervention or by raising interest rates. Given that the
abrupt depreciation of the currencies was attributed to an abrupt outflow of funds in the financial
markets, what alternative Asian government action might have been more successful in preventing a
substantial decline in the currencies’ values? Are there any possible adverse effects of your proposed
solution?
ANSWER: One solution is to require that capital flows be required to stay within the country for a
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