Chapter 6
Government Influence on Exchange Rates
Lecture Outline
Exchange Rate Systems
Fixed Exchange Rate System
Freely Floating Exchange Rate System
Managed Float Exchange Rate System
Pegged Exchange Rate System
Dollarization
Classification of Exchange Rate Arrangements
A Single European Currency
Impact on Eurozone Monetary Policy
Impact on Firms in the Eurozone
Government Intervention
Reasons for Government Intervention
Direct Intervention
Indirect Intervention
Intervention as a Policy Tool
Influence of a Weak Home Currency
Influence of a Strong Home Currency
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
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?
2. Assume that both the U.S. and Europe experience high unemployment. How can the U.S. central
bank attempt to adjust the dollar value to reduce this problem? Is the European central bank likely to
go along with the U.S. central bank’s strategy or retaliate? 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.
ANSWER: The issue is important because it affects the potential degree of economic growth in the U.S.
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
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
4. Indirect Intervention. How can a central bank use indirect intervention to change the value of a
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
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.
8. Indirect Intervention. Why would the Fed’s indirect intervention have a stronger impact on some
currencies than others? Why would a central bank’s indirect intervention have a stronger impact than
its direct intervention?
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
10. Intervention Effects on Bond Prices. U.S. bond prices are normally 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 intervention.
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.
ANSWER: The higher interest rates did not attract sufficient funds to offset the outflow of funds, as
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
17. Effects of September 11. Within a few days after the September 11, 2001 terrorist attack on the U.S.,
the Federal Reserve reduced short-term interest rates in the U.S. to stimulate the U.S. economy. How
might this action have affected the foreign flow of funds into the U.S. and affected the value of the
dollar? How could such an effect on the dollar increase the probability that the U.S. economy would
strengthen?
18. Intervention Effects on Corporate Performance. Assume you have a subsidiary in Australia. The
subsidiary sells mobile homes to local consumers in Australia, who buy the homes using mostly
borrowed funds from local banks. Your subsidiary purchases all of its materials from Hong Kong.
The Hong Kong dollar is tied to the U.S. dollar. Your subsidiary borrowed funds from the U.S.
parent, and must pay the parent $100,000 in interest each month. Australia has just raised its interest
rate in order to boost the value of its currency (Australian dollar, A$). The Australian dollar
appreciates against the dollar as a result. Explain whether these actions would increase, reduce, or
have no effect on:
a. The volume of your subsidiary’s sales in Australia (measured in A$),
b. The cost to your subsidiary of purchasing materials (measured in A$)
c. The cost to your subsidiary of making the interest payments to the U.S. parent (measured in A$).
Briefly explain each answer.
ANSWER:
19. Pegged Currencies. Why do you think a country suddenly decides to peg its currency to the dollar or
some other currency? When a currency is unable to maintain the peg, what do you think are the
typical forces that break the peg?
ANSWER: A country will usually attempt a peg to reduce speculative flows that occur because of
exchange rate volatility. It tries to comfort investors by making them believe that the currency will be
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 $.04. Assume that the Bank of England had not
been intervening in the foreign exchange markets in the last several months. However, it announces at
10:01 a.m. that it will begin to frequently intervene in the foreign exchange market in order to reduce
fluctuations in the pound’s value against the dollar over the next year, but it will not attempt to push
the pound’s value higher or lower than what is dictated by market forces. Also, the Bank of England
has no plans to affect economic conditions with this intervention. Most participants who trade
currency options did not anticipate this announcement. When they heard the announcement, they
expected that the intervention would be successful in achieving its goal. Will this announcement
cause the premium on the one-year call option on British pounds to increase, decrease, or to be
unaffected? Explain.
22. Speculating Based on Intervention. Assume that you expect that the European central bank (ECB)
plans to engage in central bank intervention in which it plans to use euros to purchase a substantial
amount of U.S. dollars in the foreign exchange market over the next month. Assume that this direct
intervention is expected to be successful at influencing the exchange rate.
a. Would you purchase or sell call options on euros today?
b. Would you purchase or sell futures on euros today?
ANSWER:
23. Implications of a Fixed Currency for International Trade. Assume the Hong Kong dollar
(HK$) 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, a HK$=0.30 Singapore dollars. Assume that there is much trade in the
computer industry among Singapore, Hong Kong, and the U.S. and that all products are viewed as
Government Influence on Exchange Rates ❖ 9
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.
b. Will the computer exports from Singapore to the U.S. increase, decrease, or remain the same?
Briefly explain.
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 zaps) that serve as substitutes for products
produced in the U.S. and many other countries. Zapakar’s currency (called 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 would increase, decrease, or remain the same?
ANSWER:
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.
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.
ANSWER:
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 it 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
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.
Government Influence on Exchange Rates ❖ 11
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:
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.
ANSWER: Coordinated intervention occurs when central banks agree to use similar direct
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.
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:
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.
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
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.
Using nonsterilized intervention, a central bank intervenes in the foreign exchange market without
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 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
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
Government Influence on Exchange Rates ❖ 15
Solution to Supplemental Case: Hull Importing Company
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.
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?
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?
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
Government Influence on Exchange Rates ❖ 17
(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
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
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.)
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?