Upload
radhika39
View
221
Download
0
Embed Size (px)
Citation preview
8/7/2019 EXCHANGE RATE BEHAVIOUR
1/21
1
EXCHANGE RATE SYSTEM
8/7/2019 EXCHANGE RATE BEHAVIOUR
2/21
2
EXCHANGE RATE
y THE RATE AT WHICH ONE CURRENCY CAN
BE EXCHANGED FOR ANOTHER.y THE VALUE PER UNIT OF ONE CURRENCY
IN TERMS OF ANOTHER CURRENCY.
8/7/2019 EXCHANGE RATE BEHAVIOUR
3/21
3
Exchange Rate System
Exchange rate systems can be classified according to the degree by which
exchange rates are continuously followed by the government.
Exchange rate system normally fall into one of the
following categories: -
y Fixed
y Freely floating
y
Managed floaty Pegged
3
8/7/2019 EXCHANGE RATE BEHAVIOUR
4/21
4
Fixed Exchange Rate System
y
In a fixed exchange rate system, exchange rates are either held constant orallowed to fluctuate only within very narrow boundaries. A fixed exchange ratewould be beneficial to a country for the following reasons: -
1. Exporters or importers could engage in international trade without concernabout exchange rate movements of the currency to which their local currency
is linked.2. Any firms that accept the foreign currency as payment would be insulted
from the risk that the currency could depreciate over time; in addition anyfirms that need to obtain that foreign currency in the future would beinsulated from the risk of the currency appreciating over time.
3. Another benefit is that firms could engage in direct foreign investment,without concern about exchange rate movements of that currency, theywould be able to convert their foreign currency earning into their homecurrency without concern that the foreign currency denominating theirearning might weaken over time. Thus the management of an MNC would bemuch easier.
4
8/7/2019 EXCHANGE RATE BEHAVIOUR
5/21
5
General points
If an exchange rate begins to move too much, government intervenes to maintain
it within the boundaries. In some situation, a government will devalue or reduce the
value of its currency against other currencies. In other situation, it will revalue or
increase the value of its currency against other currencies.
A central banks action to devalue a currency in a fixed exchange rate system is
referred to as devaluation.. Devaluation refers to a downward adjustment of the
exchange rate by the central bank. Conversely revaluation refers to an upward
adjustment of the exchange rate by the central bank.
5
8/7/2019 EXCHANGE RATE BEHAVIOUR
6/21
6
Advantages ofFixed Exchange Rates to MNCs
1. In a fixed exchange rate environment, MNCs may be able
to engage in international trade, direct foreign investment,
and international finance without worrying about thefuture exchange rate.
Consequently, the managerial duties of an MNC are
less difficult.
6
8/7/2019 EXCHANGE RATE BEHAVIOUR
7/21
7
Disadvantages ofFixed Exchange Rates to MNCs
1. One disadvantages of a fixed exchange rate system is that there is still
risk that the government will alter the value of a specific currency.
Although an MNC is not exposed to continual movements in an
exchange rate, it does face the possibility that its government will
devalue or revalue its currency.
2. A second disadvantage is that from a macro / worldwide point of view,
a fixed exchange rate system may make each country and its MNCs
more vulnerable / weak / helpless .condition in other countries.
7
8/7/2019 EXCHANGE RATE BEHAVIOUR
8/21
8/7/2019 EXCHANGE RATE BEHAVIOUR
9/21
9
FREELYFLOTING EXCHANGE RATE SYSTEM
y
In a freely floating exchange rate system, exchange rate values aredetermined by market forces without intervention by government.
Whereas a fixed exchange rate system allows no flexibility for
exchange rate movements, a freely floating exchange rate system allows
complete flexibility.
y A freely floating exchange rate adjusts on a continual basis in response todemand and supply conditions for that currency.
y Advantages: -
One advantages of a freely floating exchange rate system is that a country
is more insulated from the inflation of other countries.
9
8/7/2019 EXCHANGE RATE BEHAVIOUR
10/21
10
Example
y Continue with the previous example in which there are only two
countries, but now assume a freely floating exchange rate system. If the USexperienced high rate inflation, the increased US demand for British goods
will place upward pressure on the value of the British pound. As second
consequences of the high US inflation, the reduced British demand for US
goods will result in a reduced supply of pounds for sale (exchanged for
dollar
y The pound will appreciate due to these market forces (it was not allowed
to appreciate under the fixed rate system). This appreciation will make
British goods more expensive for US consumers even through British
produced did not raise their prices. The higher prices will simply be due tothe pounds appreciation; (that is, a greater number of US dollars are required to
buy the same number of pounds as before)
10
8/7/2019 EXCHANGE RATE BEHAVIOUR
11/21
11
Other Advantages
y Another advantage of freely floating exchange rates is that a country is more insulated
from unemployment problems in other countries.
y Example: -
Under a floating rate system, the decline in US purchase of British goods will reflect a
reduced US demand for British pounds. Such a shift in demand can cause the pound todepreciate against the dollar (under the fixed rate system, the pound would not be allowed
to depreciate).
The depreciation of the pound will make British goods look cheap to US
consumers, offsetting the possible reduction in demand for these goods resulting from a
lower level of US income.
As was true with, a sudden change in unemployment will have less influence on a
foreign country under a floating rate system than under a fixed rate system.
11
8/7/2019 EXCHANGE RATE BEHAVIOUR
12/21
8/7/2019 EXCHANGE RATE BEHAVIOUR
13/21
8/7/2019 EXCHANGE RATE BEHAVIOUR
14/21
14
PEGGED EXCHANGE RATE SYSTEM
ySome countries use a pegged exchange rate arrangement, in which theirhome currencys value is pegged / attached to a foreign currency. While
the home currencys value is fixed in terms of the foreign currency to
which it is pegged, it moves in line with that currency against other
currencies.
y Some government peg their currencys value to that of a stable
currency, such as the dollar, because the value of their currency to be
stable.
y First, this force their currencys exchange rate with the dollar be fixed,
second, their currency will move against non dollar currencies by thesame degree as the dollar. Since the dollar is more stable than most
currencies, it will make their currency more stable than most
currencies.
14
8/7/2019 EXCHANGE RATE BEHAVIOUR
15/21
15
Limitations ofPegged Exchange Rate
y While countries with a pegged exchange rate may attract foreign investment because the
exchange rate is expected to remain stable, but weak economic or political conditions
can cause firms and investors to question whether the peg will hold.
y For example: -
If the country suddenly experiences a recession, it may experience capitaloutflows as some firms and investors withdraw funds because they believe there are
better investment opportunities in other countries.
These transaction result in an exchange of the local currency for dollars and other
currencies,which places downward pressure on the local currency value.
The central bank would need to offset this by intervening in the foreign exchangemarket, so they might be not able to maintain that peg.
If the peg is broken than the exchange rate will dictated by the market forces,
than local currencies value would decline immediately.
15
8/7/2019 EXCHANGE RATE BEHAVIOUR
16/21
16
y If foreign investors fear that a peg may be broken, they quickly sell their
investment in that country and convert the proceeds into their home
currency. This trancation place more downward pressure on the localcurrency of that country.
y For the reasons explained here, countries have difficulty maintaining a peg
exchange rate when they are experiencing major political or economicproblems.
y While a country with a stable exchange rate can attract foreign
investments, the investors will move their funds to another country if
there are concerns that the peg will break.
y Thus a pegged exchange rate system could ultimately create instability in a
currencys economy.16
8/7/2019 EXCHANGE RATE BEHAVIOUR
17/21
17
Examples of Critics
y Creation of Europes snake arrangement: - one of the best known
pegged exchange rate arrangement was establishment by several
European countries in April 1972.
y Their goal was to maintain their currencies within established
limits of each other.This arrangement became known as snake.
y The snake was difficult to maintain, however and maker pressurecaused some currencies to move outside their established limits
consequently, some members withdrew from the snake
arrangement, and some currencies were realigned.
17
8/7/2019 EXCHANGE RATE BEHAVIOUR
18/21
18
Creation of the European monetary system (EMS)
y Due to continued problems with the snake arrangement, the European monetary
system was pushed into operation in March 1979. The EMS concept was similar to the
snake,but the specific characteristics differed.
y Under the EMS exchange rates of members countries were held together within
specified limits and were also tied to the European currency units. Its value was
weighted average of exchange rates of the member countries each weight was
determined by a member; relative gross national product and activity in intra-European
trade.
y The currencies of these countries were allowed to fluctuate by more than 2.25% and
6% for some currencies from the initially established values.
y The method of linking European currency values with ECU was known as the exchange
rate, mechanism, (ERM). The participating governments intervened in the foreign
exchange markets to maintain the exchange rates within boundaries by the ERM.
18
8/7/2019 EXCHANGE RATE BEHAVIOUR
19/21
19
Demises of the European Monetary system
y In the fall of 1992, however, the exchange rate mechanism experienced severeproblems, as economic conditions and goals began to vary among Europeans centuries.
y The German government was mostly concerned about inflation because its economy
was relatively strong. It increased local interest rates to present excessive spending and
inflation other European governments, however were most concerned about stimulatingtheir economies to lower their high unemployment levels, so they wanted to reduce
interest rates.
y In Oct 1992 the British and Italian government suspended their participation in the
ERM because they could not achieve their own goals for a stronger economy while theirinterest rates were so highly influenced by the German interest rates.
19
8/7/2019 EXCHANGE RATE BEHAVIOUR
20/21
20
The break in chinas pegged exchange rate
y
y From 1996 to until 2005, chinas Yuan was pegged to be worth about $ 12(8.28 Yuan perUS dollar). During this period the Yuans value would change against non dollar
currencies on a daily basis to the same degree as the dollar.
y Because of the peg, the Yuans value remained at that level even though the US was
experiencing a trade deficit of more than $100 billion per year with China. US politiciansargued that the Yuan was being held at a superficially low level by the Chinese
government, and if it was allowed to float, its value would raise 10 to 20%.
y The politicians were pressured by US firms that lost business to Chinese exports. In 2005
some politicians argued that an explicit tax of about 30% should be imposed on allproducts imported from China. In response to growing critics China revalued its Yuan by
2.1% in July 2005. It also agreed to allow Yuan to float subject to a .3% limit every day
from previous days closing, but it did not have a major impact on the trade imbalance
between China and US. In May 2007 china widened its band so that Yuans value could
float subject to .5% limit per day.20
8/7/2019 EXCHANGE RATE BEHAVIOUR
21/21
21
y Even through the Yuan is not allowed to float, (within the limit), the
huge balance of trade deficit was not automatically force appreciation
of Yuan. Large net capital flows from china to the US (purchase of US
securities) could offset the trade flows.
21