Understand the range of possible government policies toward EX market Know how to analysis of these policies Explore some lessons of history by surveying exchange rate systems that have existed during the past 130 years
Policies Toward Exchange Rates

Choice of regime:

Flexible exchange rates

Pure float Dirty/managed float

Fixed exchange rates Degree and types of intervention
1.
Fixing the Value of the Currency

Fix to gold

This was the way it was done a century ago. When all currencies are tied to the same commodity, they are all effectively tied to each other.

A managed or dirty float is an approach in which the government generally allows the exchange rates to float, but periodically chooses to intervene to influence the market rate.
Fixed Exchange Rates

Under a fixed exchange rate regime, the government sets the exchange rate it wants.


Some flexibility is allowed within a narrow trading range, called a band. The official, chosen fixed rate is called the par value or central value.
Pegs (Continued)

Crawling peg



The exchange rate is changed often, but only by official revaluation. Best of both worlds? Allows some degree of stability and control, as well as some degree of flexibility. The peg move according to some set of indicators, or according to the gov’t monetary authority.
Exchange Rate Regimes


We will discuss the various types of regimes in the discussion that follows: Floating (Flexible) Exchange Rate

Pure (clean) float Managed (dirty) float Pegged exchange rate Adjustable peg Crawling peg
Fixing to a Basket of Currencies

The Special Drawing Right (SDR) is one possibility for a fix.



It is a basket of the four major currencies of the world. It is a reserve asset created by the International Monetary Fund (IMF) As of 2002, the value of one SDR was:
Chapter Outline


Why are government policies toward EX rates Range of choices : floating rate and Fixed rate Exchange controls as aicies

Fixed Exchange Rate


Floating Exchange Rate

Pure or clean float: the government allows the market to determine the exchange rate.
Floating Exchange Rate (Continued)

Central bankers set the rate much as the Fed changes the discount rate.
Four ways to Defend the Fix

Exchange Controls


Capital Controls




One example of exchange controls is for the gov’t to allow use of foreign exchange for import-export, but not for payments related to financial activities. Thus the currency is convertible for “current transactions” but not for “capital/financial” transactions. There may be limits on int’l financial transactions, or special approvals required. Hence these are referred to as capital controls.

US$0.577 0.426 euros 21 Japanese yen British £0.0984
Pegs


Permanent fix? Pegged exchange rate—implies that the government probably will exercise its right, at some point(s), to “move” the peg. Adjustable peg—implies that the gov’t will adjust the level of the peg as required in the face of substantial fundamental changes in the country’s international position.



Fix to a “basket” of commodities (a commodity price index). Fix to another currency—from WWII until 1970 the U.S. fixed its currency to gold and most other nations fixed their currency to the U.S. dollar. Fix to a “basket” of currencies—takes advantage of averaging to reduce volatility and to insulate the currency.
Welcome to International Finance
Nanjing University of Economic and Finance
Chapter Six
Government Policies toward the FX Market
Learning Objectives


Fixed Exchange Rates (Continued)

Design of a fixed exchange rate system requires answers to the following questions:
To what do you fix the value of the currency? 2. When or how often do you change the fixed value? 3. How do you defend the fixed value against market pressures?
Polices that Restrict Access

No restrictions

Everyone is free to use the foreign exchange market. The country’s currency is fully convertible into foreign currency for all uses.
Reasons for Policies




Stabilization—reduce the variability in the exchange rates to encourage trade. A government may want to keep the exchange value of its currency low to encourage exports and discourage imports. In potentially inflationary periods, a government may want to keep the exchange value of its currency high to encourage imports and provide price competition designed to keep domestic prices in check. A strong currency or steady exchange rate may be considered as a point of national pride.