Isna Ramadhani

C1B014001

Government Influence on Exchange Rates

Exchange Rate Systems

Exchange rate systems normally fall into one
of the following categories:
Fixed
Freely floating
Managed float
Pegged

Fixed Exchange Rate System

In a fixed exchange rate system, exchange rates are either held constant or allowed to
fluctuate only within very narrow boundaries.
a. Advantages of Fixed Exchange Rates to MNCs.
In a fixed exchange rate environment, MNCs may be able to engage in international
trade, direct foreign investment, and international fi nance without worrying about the
future exchange rate.
b. Disadvantages of Fixed Exchange Rates to MNCs
There is still risk that the government will alter the value of a specific currency

Freely Floating Exchange Rate System

In a freely floating exchange rate system, exchange rate values are determined by market
forces without intervention by governments.
a. Advantages of a Freely Floating Exchange Rate System
One advantage of a freely floating exchange rate system is that a country is more
insulated from the inflation of other countries.

b. Disadvantages of a Freely Floating Exchange Rate

System.
Freely floating exchange rate system can adversely affect a country that has high
unemployment.

Float Exchange Rate System

Exchange rates are allowed to fluctuate on a daily basis and there are no official
boundaries.

Pegged Exchange Rate System

Some countries use a pegged exchange rate arrangement, in which their home currencys
value is pegged to a foreign currency or to some unit of account.

Government Intervention
Reasons for Government Intervention
The degree to which the home currency is controlled, or managed, varies among
central banks. Central banks commonly manage exchange rates for three reasons:
To smooth exchange rate movements
To establish implicit exchange rate boundaries
To respond to temporary disturbances

Direct Intervention
To force the dollar to depreciate, the Fed can intervene directly by exchanging dollars
that it holds as reserves for other foreign currencies in the foreign exchange market.

Indirect Intervention

where
e = percentage change in the spot rate
INF = change in the differential between U.S. inflation and the foreign
countrys inflation

INT = change in the differential between the U.S. interest rate and the
foreign countrys interest rate
INC = change in the differential between the U.S. income level and the
foreign countrys income level
GC = change in government controls
EXP = change in expectations of future exchange rates