International Finance Tutorial TUTORIAL Exchange Rate Systems and Government Intervention TRUE-FALSE QUIZ A currency board is a system for maintaining the value of the local currency with respect to some other specified currency To this, the currency board must have credibility in its promise to maintain the exchange rate a True Correct Without credibility, actions taken to maintain the currency at the specified level would have little effect Three members of the European Union initially decided not to participate in the single European currency (euro) These countries are the United Kingdom, Denmark, and Sweden a True Correct These are the three countries that initially chose not to participate The European Central Bank is based in Frankfurt and is responsible for setting monetary policy for all participating European countries Its objective is to control inflation in the participating countries and to stabilize the value of the euro with respect to other major currencies a True Correct One method of direct intervention by the U.S Federal Reserve System in currency markets is to sell dollars and buy foreign currencies to make the U.S dollar depreciate a True Correct "Flooding the market with dollars" is direct intervention by the Fed to place downward pressure on the dollar by increasing its supply and increasing the demand for another currency Indirect intervention occurs when the Fed affects the dollar's value indirectly by influencing the factors that determine it Dollarization represents the replacement of a foreign currency with U.S dollars This process is a little less drastic than a currency board a False Correct While dollarization is the replacement of a foreign currency with U.S dollars, it is a step beyond a currency board, because it forces the local currency to be the pegged to the U.S dollar MULTIPLE CHOICE QUIZ Some countries use a _ exchange rate arrangement, in which their home currency's value is pegged to a foreign currency or to some unit of account a fixed Incorrect In a fixed exchange rate system, exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries If an exchange rate begins to move too much, governments can intervene to maintain it within the boundaries In some situations, a government would devalue or reduce the value of its currency against other currencies International Finance Tutorial b freely floating Incorrect In a freely floating exchange rate system, exchange rate values would be determined by market forces without intervention by various governments c managed float Incorrect A managed float resembles the freely floating system in that exchange rates are allowed to fluctuate on a daily basis and official boundaries not exist Yet, it is similar to the fixed system in that governments can and sometimes intervene to prevent their currencies from moving too much in a certain direction d pegged Correct Under a pegged system, while the home currency's value is fixed in terms of the foreign currency (or unit of account) to which it is pegged, it moves in line with that currency against other currencies e none of the above Incorrect Answer d is correct Which of the following strategies would result in successful sterilized intervention by the Fed if it wanted to make the U.S dollar depreciate in value? a sell dollars in the currency markets, buy government treasury bonds Incorrect Both of these actions would increase the money supply, making the intervention unsterilized b sell dollars in the currency markets, sell government treasury bonds Correct This would increase the supply of dollars in the currency market (causing depreciation) and the sale of government securities would leave the money supply unchanged c buy dollars in the currency markets, buy government treasury bonds Incorrect This would decrease the supply of dollars on the currency market (causing appreciation) and the purchase of government securities would increase the money supply d buy dollars in the currency markets, sell government treasury bonds Incorrect Both of these actions would decrease the money supply, making the actions unsterilized and making the dollar appreciate Assume the Fed wants to boost exports for the United States Which of the following strategies would help boost exports? a raise interest rates Incorrect This would make the dollar appreciate An appreciation of the currency should reduce exports b increase the money supply by selling government bonds Incorrect Although an increase in the money supply would result in dollar depreciation, selling government bonds would decrease the money supply c lower interest rates Correct Lower interest rates would make the dollar depreciate A depreciation of the currency should help boost exports d decrease the money supply by selling government bonds Incorrect This would make the dollar appreciate An appreciation of the currency should reduce exports e none of the above Incorrect Answer c is the correct answer International Finance Tutorial Assume the Fed wants to decrease inflation in the United States Which of the following strategies would help reduce inflation? a raise interest rates Correct A strong (appreciating currency) will dampen inflation Increasing interest rates would make the dollar appreciate b increase the money supply by buying government bonds Incorrect Increasing the money supply would weaken the currency and cause an increase in inflation c lower interest rates Incorrect This would make the dollar depreciate and potentially increase inflation d decrease the money supply by buying government bonds Incorrect Although a decrease in the money supply would result in currency appreciation, buying government bonds increases the money supply DISCUSSION QUESTION What the European Union nations hope to gain from the introduction of the euro? What risks does the introduction of the euro present? How can your business be affected if the State Bank of Vietnam attempts to strengthen/ weaken the Vietnamese dong in the foreign exchange market? How can indirect central bank intervention affect your business even if there is no impact on exchange rate? APPLICATION QUESTIONS Chapter 6: Question 13 and 15 on page 197 of Madura 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 When Chile's interest rates decline, there is a smaller flow of funds to be exchanged into Chilean pesos because the Chile interest rate is not as attractive to investors There may be a shift of investment into the other Latin American countries where interest rates have not declined However, if these Latin American countries are expected to reduce their rates as well, they will not attract more capital and may even attract less capital flows in the future, which could reduce their values b How would the central banks of other Latin American countries likely adjust their interest rates? How would the currencies of these countries respond to the central bank interventions? ANSWER: The central banks would likely attempt to lower interest rates, which causes the currency to weaken A weaker currency and lower interest rates can stimulate the economy c How would a U.S firm that exports products to Latin American countries be affected by the central bank interventions? (Assume the exports are denominated in the corresponding Latin American currency for each country.) ANSWER: The exporter is adversely affected if the Chilean peso and other currencies depreciate It is favorably affected by the appreciation of any Latin 15 Indirect Intervention During the Asian crisis, 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 investors had no confidence that the currencies would stabilize and were unwilling to invest in Asia