Chapter 5
Exchange Rate Systems
QUESTIONS
1. How can you quantify currency risk in a floating exchange rate system?
Answer: To characterize the risk of a currency position, you must try to characterize the
conditional distribution of the future exchange rate changes. With floating exchange rates,
historical information provides useful information about this distribution. For example, you
2. Why might it be hard to quantify currency risk in a target zone system or a pegged
exchange rate system?
3. What is likely to be the most credible exchange rate system?
4. How can a central bank create money?
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Answer: First, because the central bank operates the only authorized printing press in the
5. What are official international reserves of the central bank?
6. What is likely to happen if a central bank suddenly prints a large amount of new
money?
7. What is the effect of a foreign exchange intervention on the money supply? How can a
central bank offset this effect and still hope to influence the exchange rate?
Answer: When a central bank buys (sells) foreign currency, its international reserves increase
(decrease), and the money supply increases (decreases) simultaneously. To offset the effect
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14. What is the difference between a target zone and a crawling peg?
15. How can central banks defend their currency—for example, if the currency is within a
target zone or pegged at a particular value?
Answer: The monetary authorities in the countries with weaker currencies have three basic
defense mechanisms available: interventions, interest rate increases, and capital controls.
16. What was the EMS?
17. What is a basket currency?
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18. What did the Maastricht Treaty try to accomplish?
19. What is an optimum currency area?
20. Do you believe its monetary union will be beneficial for Europe?
21. Do you think the euro will survive?
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PROBLEMS
1. Toward the end of 1999, the central bank (Reserve Bank) in Zimbabwe stabilized the
Zimbabwe dollar, the Zim for short, at Z$38/USD and privately instructed the banks to
maintain that rate. In response, at the end of 1999, an illegal market developed wherein
the Zim traded at Z$44/USD. Are you surprised at rumors that claim corporations in
Zimbabwe were “hoarding” USD200 million? Explain.
Answer: The existence of an illegal exchange market indicates that the Zim is incorrectly
valued at Z$38/USD. Clearly, the Zim is over-valued at the official rate (See Exhibit 5.10 for
2. In Chapter 3, we described how exchange rate risk could be hedged using forward
contracts. In pegged or limited-flexibility exchange rate systems, countries imposing
capital controls sometimes force their importers and exporters to hedge. First,
assuming that forward contracts are to be used, and an exporter has future foreign
currency receivables, what will the government force him to do? Second, how does this
help the government in defending their exchange rate peg?
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3. In years past, Belgium, a participant of the former EMS, and South Africa operated a
two-tier, or dual, exchange rate market. The two-tier market was abolished in March
1990 in Belgium and in March 1995 in South Africa. Import and export transactions
were handled on the official market, and capital transactions were handled on the
financial market, where the “financial” exchange rate was freely floating. Discuss why
such a system may prevent speculators from profiting when betting on devaluation.
4. The Kuna is the currency of Croatia. Find the web site of Croatia’s central bank, and
determine the exchange rate system Croatia runs? Suppose the Kuna weakens
substantially relative to the euro. Which action can the central bank take to keep its
currency system functioning properly?
Answer: The web site of Croatia’s central bank, called the Croatian National Bank, is at
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5. Type “People’s Bank of China” into your favorite search engine and go to the English
versions of the web site. Under “Statistics” find the Balance Sheet of the Monetary
Authority. Calculate the growth rate of base money and the growth rate of
international assets for the last few years. How much foreign exchange intervention is
China doing? Are they sterilizing it?
Answer: The URL for the English version of the People’s Bank of China is
http://www.pbc.gov.cn/english/130437/index.html. However, we could not locate the old tab