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27. Intervention and Pegged Exchange Rates. Interest rate parity exists and will continue to exist. The
one-year interest rate in the U.S. and in the eurozone is 6% and will continue to be 6%. Assume that
the country of Latvia's currency (called the Lat) is presently pegged to the euro and will remain
pegged to the euro in the future. Assume that you expect that the European central bank (ECB) to
engage in central bank intervention in which it plans to use euros to purchase a substantial amount of
U.S. dollars in the foreign exchange market over the next month. Assume that this direct intervention
is expected to be successful at influencing the exchange rate.
a. Will the spot rate of the Lat against the dollar increase, decrease, or remain the same as a result of
central bank intervention?
b. Will the forward rate of the euro against the dollar increase, decrease, or remain the same as a
result of central bank intervention?
c. Would the ECB's intervention be intended to reduce unemployment or reduce inflation in the
Eurozone?
d. If the ECB decided to use indirect intervention instead of direct intervention to achieve its
objective of influencing the exchange rate, would it increase or reduce the interest rate in the
Eurozone?
e. Based on your answer to part (d), will the interest rate of Latvia increase, decrease, or remain the
same as a result of the ECB's indirect intervention?
ANSWER:
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.
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Government Influence on Exchange Rates 2
ANSWER:
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.
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.
31. Effects of Central Bank Intervention. 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.
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:
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Government Influence on Exchange Rates 3
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:
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:
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Government Influence on Exchange Rates 4
CRITICAL THINKING
Cause and Effects of a Currency Crisis Select a currency in a country that has experienced a crisis in
the last year using an online search term such as “currency crisis.” Write a short essay to describe the
underlying reasons for the currency crisis. Explain how the weakness of the currency has affected the
economic conditions in that country. Does it appear that the currency’s weakness caused a crisis in the
country or did an economic crisis in the country cause a weak currency? Did the country’s central bank
use direct intervention in an attempt to resolve the crisis? If so, was it successful?
ANSWER
Solution to Continuing Case Problem: Blades, Inc.
1. Did the intervention effort by the Thai government constitute direct or indirect intervention? Explain.
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.
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
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Government Influence on Exchange Rates 5
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?
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?
5. What do you think will happen to the Thai baht’s value when the swap arrangement is completed?
How will this affect Blades?
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.
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Government Influence on Exchange Rates 6
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.
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)?
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?
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)?
3. During the Asian crisis, direct intervention did not prevent depreciation of currencies. Offer your
explanation for why the interventions did not work.
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Government Influence on Exchange Rates 7
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?
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?
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?
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?
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?
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?
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Government Influence on Exchange Rates 8
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?
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?
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?
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.)
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
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Government Influence on Exchange Rates 9
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?
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permitted in a license distributed with a certain product or service or otherwise on a password-protected website for classroom use.
