AFW3331 Suggested answers for Tutorial 1 Week 2

AFW 3331 Suggested Solutions to Tutorial Questions

Tutorial 1 Introduction to International Finance and International Financial System
Q1 Discuss the following exchange rate regimes: a) Fixed exchange rate regime: The country pegs (fixes) its currency (formally or de facto) at a fixed rate to a major currency like USD or to a basket of currencies, where the exchange rate fluctuates within a narrow margin or at most 1% around a central rate.

b)

Free floating exchange rate regime: The exchange rate is market determined, with degree of fluctuations based on the demand and supply of the domestic currency against another foreign currency. In this type of regime, the central bank does not intervene to manage the domestic currency fluctuation.

c) Target zone exchange rate arrangement: The country allows it currency to fluctuate within a narrow band (normally 1%) against other foreign currency. The exchange rate is adjusted periodically to reflect the changes in economic fundamentals.

d) Managed float exchange rate arrangement: Rate is determined by market forces, but occasionally with central banks interventions to smooth out large fluctuations. Somewhere between fixed and floating exchange rate systems. This arrangement is also referred as dirty float.

AFW3331 Suggested answers for Tutorial 1 Week 2

Q.2 Answer the following questions from Moffett et.al. Chapter 3 2. Causes of Devaluation. If a country follows a fixed exchange rate regime, what macroeconomic variables could cause the fixed exchange rate to be devalued? The following macroeconomic variables could cause the fixed exchange rate to be devalued: An interest rate that is too low compared to other competing currencies. A continuing balance of payments deficit. An inflation rate consistently higher than in other countries. 3. Fixed versus Flexible Exchange Rates. What are the advantages and disadvantages of fixed exchange rates? Fixed rates provide stability in international prices for the conduct of trade. Stable prices aid in the growth of international trade and lessen risks for all businesses. Fixed exchange rates are inherently anti-inflationary, requiring the country to follow restrictive monetary and fiscal policies. This restrictiveness, however, can often be a burden to a country wishing to pursue policies that alleviate continuing internal economic problems, such as high unemployment or slow economic growth. Fixed exchange rate regimes necessitate that central banks maintain large quantities of international reserves (hard currencies and gold) for use in the occasional defense of the fixed rate. As international currency markets have grown rapidly in size and volume, increasing reserve holdings has become a significant burden to many nations. Fixed rates, once in place, may be maintained at rates that are inconsistent with economic fundamentals. As the structure of a nations economy changes, and as its trade relationships and balances evolve, the exchange rate itself should change. Flexible exchange rates allow this to happen gradually and efficiently, but fixed rates must be changed administrativelyusually too late, too highly publicized, and at too large a onetime cost to the nations economic health.

AFW3331 Suggested answers for Tutorial 1 Week 2

4. The Impossible Trinity. Explain what is meant by concept of the impossible trinity and why it is accurate. Countries with floating rate regimes can maintain monetary independence and financial integration but must sacrifice exchange rate stability. Countries with tight control over capital inflows and outflows can retain their monetary independence and stable exchange rate, but surrender being integrated with the worlds capital markets. Countries that maintain exchange rate stability by having fixed rates give up the ability to have an independent monetary policy.

Q3.

a).

What are the five basic mechanisms for establishing exchange rates? ANSWER. The five basic mechanisms for establishing exchange rates are free float, managed float, target-zone arrangement, fixed-rate system, and the current hybrid system.

b).

How does each work? ANSWER. In a free float, exchange rates are determined by the interaction of currency supplies and demands. Under a system of managed floating, governments intervene actively in the foreign exchange market to smooth out exchange rate fluctuations in order to reduce the economic uncertainty associated with a free float. Under a target-zone arrangement, countries adjust their national economic policies to maintain their exchange rates within a specific margin around agreed-upon, fixed central exchange rates. Under a fixed-rate system, such as the Bretton Woods system, governments are committed to maintaining target exchange rates. Each central bank actively buys or sells its currency in the foreign exchange market whenever its exchange rate threatens to deviate from its stated par value by more than an agreed-on percentage. Currently, the international monetary system is a hybrid system, with major currencies floating on a managed basis, some currencies freely floating, and other currencies moving in and out of various types of pegged exchange rate relationships.

AFW3331 Suggested answers for Tutorial 1 Week 2

c). What costs and benefits are associated with each mechanism? Benefits of a Floating Rate System. At the time floating rates were adopted in 1973, proponents said that the new system would reduce economic volatility and facilitate free trade. In particular, floating exchange rates would offset international differences in inflation rates so that trade, wages, employment, and output would not have to adjust. High-inflation countries would see their currencies depreciate, allowing their firms to stay competitive without having to cut wages or employment. At the same time, currency appreciation would not place firms in low-inflation countries at a competitive disadvantage. Real exchange rates would stabilize, even if permitted to float in principle, because the underlying conditions affecting trade and the relative productivity of capital would change only gradually; and if countries would coordinate their monetary policies to achieve a convergence of inflation rates, then nominal exchange rates would also stabilize. Another benefit is thatas Milton Friedman points outwith a floating exchange rate, there never has been a foreign exchange crisis. The reason is simple: The floating rate absorbs the pressures that would otherwise build up in countries that try to peg the exchange rate while simultaneously pursuing an independent monetary policy. For example, the Asian currency crisis did not spill over to Australia and New Zealand because the latter countries had floating exchange rates. A floating rate system can also act as a shock absorber to cushion real economic shocks that change the equilibrium exchange rate.

Costs of a Floating Rate System. Many economists point to excessive volatility as a major cost of a floating rate system. The experience to date is that the dollar's ups and downs have had little to do with actual inflation and a lot to do with expectations of future government policies and economic conditions. Put another way, real exchange rate volatility has increased, not decreased, since floating began. This instability reflects, in part, nonmonetary (or real) shocks to the world economy, such as changing oil prices and shifting competitiveness among countries, but these real shocks were not obviously greater during the 1980s than

AFW3331 Suggested answers for Tutorial 1 Week 2

they were in earlier periods. Instead, uncertainty over future government policies has increased. Benefits of a Managed Float. The potential benefit of a managed float is that governments can reduce the volatility associated with a freely floating exchange rate. Costs of a Managed Float. The costs of a managed float stem from the demonstrated inability of governments to recognize the difference between a temporary exchange rate disequilibrium and a permanent one. By trying to manage exchange rates when a permanent shift in the equilibrium exchange rate has occurred, governments run the risk of creating an exchange rate crisis and wasting reserves.

Benefits of a Target Zone Arrangement. The experience with the European Monetary System is that the target zone arrangement in effect forced convergence of monetary policy to that of the countryGermanywith the most disciplined anti-inflation policy and led to low inflation.

AFW3331 Suggested answers for Tutorial 1 Week 2

Costs of a Target Zone Arrangement. Maintaining a genuinely stable target zone arrangement requires the political will to direct fiscal and monetary policies at that goal and not at purely national ones. This turns out to be difficult for countries to achieve. In the case of the European Monetary System, the result was periodic currency crises. Another cost of this system is that fundamental changes in the equilibrium exchange rate cannot get reflected in actual exchange rate changes without a currency crisis occurring.

Benefits of a Fixed Rate System. A permanently fixed exchange rate system such as that achieved by a currency board, dollarization, or monetary union results in currency stability and the absence of currency crises. In a system such as existed under Bretton Woods, where there is a commitment to a fixed exchange rate system, but no mechanism to bind that commitment, you will have more monetary discipline than in a freely floating system and hence lower inflation than might otherwise be the case. Costs of a Fixed Rate System. In a permanently fixed system, the exchange rate cannot cushion the effects of real economic shocks, such as devaluation of a major competitors currency. Instead, prices must adjust. Given the lack of flexibility of many pricesbecause of government regulations or union restrictions the result of these economic shocks can be higher unemployment and less economic growth. In a system such as Bretton Woods, the result of changes in the equilibrium exchange rate will likely be currency crises and eventual devaluation or revaluation. Benefits of a Hybrid System. The current system gives countries the option to select the system that best meets their needs. However, all too often, the decision is based on political rather than economic calculations. Costs of a Hybrid System. The costs of a hybrid system, such as the one currently in place, is that there is no constraint on the choices that governments can make. The resulting choices can be good ones or bad ones.

AFW3331 Suggested answers for Tutorial 1 Week 2

d).

Have exchange rate movements under the current system of managed floating been excessive? Explain. ANSWER. Excessive movements would indicate that there are profits to be earned by betting against the market. In effect, if currency fluctuations are excessive they would exhibit the phenomenon of overshooting (i.e., currency rates would overreact to economic events and then return to equilibrium). There is no evidence that one could profit by betting that rate movements are excessive