Chapter 6
Government Influence on Exchange Rates
Lecture Outline
Exchange Rate Systems
Fixed Exchange Rate System
Impact of a Country Abandoning the Euro
Direct Intervention
Reasons for Direct Intervention
The Direct Intervention Process
Direct Intervention as a Policy Tool
Speculating on Direct Intervention
Indirect Intervention
Government Control of Interest Rates
Government Use of Exchange Controls
Government Influence on Exchange Rates ❖ 2
Chapter Theme
This chapter introduces the various exchange rate systems. In addition, it stresses the manner by which
governments can influence exchange rates. Since exchange rate movements are critical to an MNC’s
performance, and the government has much influence over these exchange rates, the MNC is affected by
government intervention.
Topics to Stimulate Class Discussion
1. If you were elected to choose between a fixed, freely floating, or a dirty float exchange rate system,
which would you choose for your home country? Why?
POINT/COUNTER-POINT:
Should China Be Forced to Alter the Value of Its Currency?
POINT: U.S. politicians frequently suggest that China needs to increase the value of the Chinese yuan
against the U.S. dollar, even since China has allowed the yuan to float (within boundaries). The U.S.
politicians claim that the yuan is the cause of the large U.S. trade deficit with China. This issue is
periodically raised not only with currencies tied to the dollar, but also with currencies that have a floating
rate. Some critics argue that the exchange rate can be used as a form of trade protectionism. That is, a
country can discourage or prevent imports and encourage exports by keeping the value of its currency
artificially low.
COUNTER-POINT: China might counter that its large balance of trade surplus with the U.S. has been
due to the differences in prices between the two countries, and that it should not be blamed for the high
U.S. prices. It might argue that the U.S. trade deficit can be partially attributed to the very high prices in
the U.S., which are necessary to cover the excessive compensation for executives and other employees at
U.S. firms. The high prices in the U.S. encourage firms and consumers to purchase goods from China.
Even if China’s yuan is revalued upward, this does not necessarily mean that the U.S. firms and
consumers will purchase U.S. products. They may shift their purchases from China to purchase products
in Indonesia or other low-wage countries rather than buy more products from the U.S. Thus, the
underlying dilemma is not China, but any country that has lower costs of production than the U.S.
WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support?
Offer your own opinion on this issue.
Government Influence on Exchange Rates ❖ 3
Answers to End of Chapter Questions
1. Exchange Rate Systems. Compare and contrast the fixed, freely floating, and managed float
exchange rate systems. What are some advantages and disadvantages of a freely floating exchange
rate system versus a fixed exchange rate system?
ANSWER: Under a fixed exchange rate system, the governments attempted to maintain exchange
rates within 1% of the initially set value (slightly widening the bands in 1971). Under a freely
2. Intervention with Euros. Assume that Belgium, one of the European countries that uses the euro as
its currency, would prefer that its currency depreciate against the dollar. Can it apply central bank
intervention to achieve this objective? Explain.
3. Direct Intervention. How can a central bank use direct intervention to change the value of a
currency? Explain why a central bank may desire to smooth exchange rate movements of its currency.
ANSWER: Central banks can use their currency reserves to buy up a specific currency in the foreign
exchange market in order to place upward pressure on that currency. Central banks can also attempt
4. Indirect Intervention. How can a central bank use indirect intervention to change the value of its
home currency?
5. Intervention Effects. Assume there is concern that the United States may experience a recession.
How should the Federal Reserve influence the dollar to prevent a recession? How might U.S.
exporters react to this policy (favorably or unfavorably)? What about U.S. importing firms?
Government Influence on Exchange Rates ❖ 4
ANSWER: The Federal Reserve would normally consider a loose money policy to stimulate the
economy. However, to the extent that the policy puts upward pressure on economic growth and
6. Currency Effects on Economy. What is the impact of a weak home currency on the home economy,
other things being equal? What is the impact of a strong home currency on the home economy, other
things being equal?
ANSWER: A weak home currency tends to increase a country’s exports and decrease its imports,
thereby lowering its unemployment. However, it also can cause higher inflation since there is a
7. Feedback Effects. Explain the potential feedback effects of a currency’s changing value on inflation.
ANSWER: A weak home currency can cause inflation since it tends to reduce foreign competition
8. Indirect Intervention. Why would the Fed’s indirect intervention have a stronger impact on some
currencies than on others? Why would a central bank’s indirect intervention have a stronger impact
than direct intervention does?
ANSWER: Intervention may have a more pronounced impact when the market for a given currency is
9. Effects on Currencies Tied to the Dollar. The Hong Kong dollar’s value is tied to the U.S. dollar.
Explain how the following trade patterns would be affected by the appreciation of the Japanese yen
against the dollar: (a) Hong Kong exports to Japan and (b) Hong Kong exports to the United States.
Government Influence on Exchange Rates ❖ 5
ANSWER:
a. Hong Kong exports to Japan should increase because the yen will have appreciated against the
Hong Kong dollar. Therefore, Hong Kong goods will be less expensive to Japanese importers.
10. Intervention Effects on Bond Prices. U.S. bond prices are usually inversely related to U.S.
inflation. If the Fed planned to use intervention to weaken the dollar, how might bond prices be
affected?
11. Direct Intervention in Europe. If most countries in Europe experience a recession, how might the
European Central Bank use direct intervention to stimulate economic growth?
12. Sterilized Intervention. Explain the difference between sterilized and nonsterilized interventions.
13. Effects of Indirect Intervention. Suppose that the government of Chile reduces one of its key
interest rates. The values of several other Latin American currencies are expected to change
substantially against the Chilean peso in response to the news.
a. Explain why other Latin American currencies could be affected by a cut in Chile’s interest rates.
ANSWER: Exchange rates are partially driven by relative interest rates of the countries of concern.
Government Influence on Exchange Rates ❖ 6
b. How would the central banks of other Latin American countries be likely to adjust their interest
rates? How would the currencies of these countries respond to the central bank intervention?
c. How would a U.S. firm that exports products to Latin American countries be affected by the
central bank intervention? (Assume the exports are denominated in the corresponding Latin
American currency for each country.)
14. Freely Floating Exchange Rates. Should the governments of Asian countries allow their currencies
to float freely? What would be the advantages of letting their currencies float freely? What would be
the disadvantages?
ANSWER: A freely floating currency may allow the exchange rate to adjust to market conditions,
15. Indirect Intervention. During the Asian crisis (see Appendix 6 at the end of this chapter), some
Asian central banks raised their interest rates to prevent their currencies from weakening. Yet, the
currencies weakened anyway. Offer your opinion as to why the central banks’ efforts at indirect
intervention did not work.
Advanced Questions
16. Monitoring the Fed’s Intervention. Why do foreign market participants monitor the Fed’s direct
intervention efforts? How does the Fed attempt to hide its intervention actions? The media frequently
reports that “the dollar’s value strengthened against many currencies in response to the Federal
Reserve’s plan to increase interest rates.” Explain why the dollar’s value may change even before the
Federal Reserve affects interest rates.
ANSWER: Foreign market participants make investment and borrowing decisions that can be
influenced by anticipated exchange rate movements and therefore by the Fed’s direct intervention
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20. Impact of Intervention on Currency Option Premiums. Assume that the central bank of the
country Zakow periodically intervenes in the foreign exchange market to prevent large upward or
downward fluctuations in its currency (the zak) against the U.S. dollar. Today, the central bank
announced that it would no longer intervene in the foreign exchange market. The spot rate of the zak
against the dollar was not affected by this news. Will the news affect the premium on currency call
options that are traded on the zak? Will the news affect the premium on currency put options that are
traded on the zak? Explain.
21. Impact of Information on Currency Option Premiums. As of 10:00 a.m., the premium on a
specific one-year call option on British pounds is $.04. Assume that the Bank of England had not
been intervening in the foreign exchange markets in the last several months. However, it announces at
10:01 a.m. that it will begin to frequently intervene in the foreign exchange market so as to reduce
fluctuations in the pound’s value against the dollar over the next year, but it will not attempt to push
the pound’s value higher or lower than what is dictated by market forces. Also, the Bank of England
has no plans to affect economic conditions with this intervention. Most participants who trade
currency options did not anticipate this announcement. When they heard the announcement, they
expected that the intervention would be successful in achieving its goal. Will this announcement
cause the premium on the one-year call option on British pounds to increase, decrease, or to be
unaffected? Explain.
22. Speculating Based on Intervention. Assume that the European central bank (ECB) plans to engage
in central bank intervention using euros to purchase a substantial amount of U.S. dollars in the foreign
exchange market over the next month. Assume that this direct intervention is expected to be
successful at influencing the exchange rate.
a. Would you purchase or sell call options on euros today?
b. Would you purchase or sell futures on euros today?
23. Implications of a Fixed Currency for International Trade. Assume the Hong Kong dollar
Government Influence on Exchange Rates ❖ 9
(HK$) value is tied to the U.S. dollar and will remain tied to the U.S. dollar. Last month, a HK$ =
0.25 Singapore dollars. Today, HK$=0.30 Singapore dollars. Assume that much trade in the computer
industry occurs among Singapore, Hong Kong, and the U.S. and that all products are viewed as
substitutes for each other and are of about the same quality. Assume that the firms invoice their
products in their local currency and do not change their prices.
a. Will the computer exports from the U.S. to Hong Kong increase, decrease, or remain the same?
Briefly explain.
ANSWER: Decrease. The H.K. dollar appreciated against the Singapore dollar while fixed against
24. Implications of a Revised Peg. The country of Zapakar has much international trade with the
U.S. and other countries, as it has no significant barriers on trade or capital flows. Many firms in
Zapakar export common products (denominated in Zapakar’s currency, called zaps) that serve as
substitutes for products produced in the U.S. and many other countries. The zap has been pegged at 8
zaps =$1 for the last several years. Yesterday, the government of Zapakar reset the zap’s currency
value so that is now pegged at 7 zaps=$1.
a. How should this adjustment in the pegged rate against the dollar affect the volume of exports by
Zapakar firms to the U.S.?
b. Will this adjustment in the pegged rate against the dollar affect the volume of exports by Zapakar
firms to non-U.S. countries? If so, explain.
c. Assume that the Federal Reserve significantly raises U.S. interest rates today. Do you think
Zapakar’s interest rate will increase, decrease, or remain the same?
25. Pegged Currency and International Trade. Assume that Canada decides to peg its currency (the
Canadian dollar) to the U.S. dollar and that the exchange rate will remain fixed. Assume that Canada
commonly obtains its imports from the U.S. and Mexico. The U.S. commonly obtains its imports
from Canada and Mexico. Mexico commonly obtains its imports from the U.S. and Canada. The
traded products are always invoiced in the exporting country’s currency. Assume that the Mexican
peso appreciates substantially against the U.S. dollar during the next year.
a. What is the likely effect (if any) of the peso’s exchange rate movement on the volume of
Canada’s exports to Mexico? Explain.
Government Influence on Exchange Rates ❖ 10
b. What is the likely effect (if any) of the peso’s exchange rate movement on the volume of
Canada’s exports to the U.S.? Explain.
26. Impact of Devaluation. The inflation rate in Yinland was 14% last year. The government of Yinland
just devalued its currency (the yin) by 40 % against the dollar. Even though Yinland produces similar
types of products as the U.S., it has much trade with the U.S. and very little trade with other countries.
It presently has trade restrictions imposed on all non-U.S. countries. Will the devaluation of the yin
increase or reduce inflation in Yinland? Briefly explain.
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
Denmark’s currency (called the krone) is presently pegged to the euro and will remain pegged to the
euro in the future. You expect that the European central bank (ECB) to engage in central bank
intervention by using 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 krone against the dollar increase, decrease, or remain the same as a result
of ECB intervention?
b. Will the forward rate of the euro against the dollar increase, decrease, or remain the same as a
result of ECB intervention?
c. Is the ECB’s intervention 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 Denmark increase, decrease, or remain
the same as a result of the ECB’s indirect intervention?
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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.
29. Central Bank Control Over Its Currency’s Value. Assume that France wants to change the
prevailing spot rate of its currency (euro) so as to improve its economy; likewise, Switzerland wants
to change the prevailing value of its currency (Swiss franc) so as 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
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.
Government Influence on Exchange Rates ❖ 12
a. Will this act increase, reduce, or have no effect on Canadian inflation? Briefly explain.
b. Ignore the actions of the Federal Reserve in part (a) and assume that the Canadian central bank
raises its interest rates. Will this action 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?
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
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.
Government Influence on Exchange Rates ❖ 13
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
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.
ANSWER: The intervention effort by the Thai government constituted direct intervention, since the
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
Government Influence on Exchange Rates ❖ 14
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
adjusting for the change in money supply. Using sterilized intervention, a central bank intervenes in
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
another. For example, if Thailand experienced relatively high levels of inflation during a fixed
4. What are some of the potential disadvantage in terms 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
5. What do you think will happen to the Thai baht’s value when the swap arrangement is completed?
How will this affect Blades?
Government Influence on Exchange Rates ❖ 15
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
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.
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?
Government Influence on Exchange Rates ❖ 17
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?
10. In most cases, a weak local currency is expected to stimulate the local economy. Yet, it appeared that
the weak currencies of Asian countries adversely affected their economies. Why do you think the
weakening of the home currencies did not initially improve these countries’ 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 taken 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?
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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
markets, what alternative action by the Asian government might have been more successful in
preventing a substantial decline in the currencies’ values? Are there any possible adverse effects of
your proposed solution?