Chapter 6. Government Influence on Exchange Rates. Lecture Outline

Transcription

1 Chapter 6 Government Influence on Exchange Rates Lecture Outline Exchange Rate Systems Fixed Exchange Rate System Freely Floating Exchange Rate System Managed Float Exchange Rate System Pegged Exchange Rate System Dollarization Classification of Exchange Rate Arrangements A Single European Currency Impact on Eurozone Monetary Policy Impact on Firms in the Eurozone Impact on Financial Flows in the Eurozone Exposure of Countries Within the Eurozone Government Intervention Reasons for Government Intervention Direct Intervention Indirect Intervention Intervention as a Policy Tool Influence of a Weak Home Currency Influence of a Strong Home Currency

2 2 Government Influence on Exchange Rates Chapter Theme This chapter introduces the various exchange rate systems. In addition, it stresses the manner by which governments can influence exchange rates. Since exchange rate movements are critical to an MNC s performance, and the government has much influence over these exchange rates, the MNC is affected by government intervention. Topics to Stimulate Class Discussion 1. If you were elected to choose between a fixed, freely floating, or a dirty float exchange rate system, which would you choose for your home country? Why? 2. Assume that both the U.S. and Europe experience high unemployment. How can the U.S. central bank attempt to adjust the dollar value to reduce this problem? Is the European central bank likely to go along with the U.S. central bank s strategy or retaliate? Why? POINT/COUNTER-POINT: Should China Be Forced to Alter the Value of Its Currency? POINT: U.S. politicians frequently suggest that China needs to increase the value of the Chinese yuan against the U.S. dollar, even since China has allowed the yuan to float (within boundaries). The U.S. politicians claim that the yuan is the cause of the large U.S. trade deficit with China. This issue is periodically raised not only with currencies tied to the dollar, but also with currencies that have a floating rate. Some critics argue that the exchange rate can be used as a form of trade protectionism. That is, a country can discourage or prevent imports and encourage exports by keeping the value of its currency artificially low. COUNTER-POINT: China might counter that its large balance of trade surplus with the U.S. has been due to the differences in prices between the two countries, and that it should not be blamed for the high U.S. prices. It might argue that the U.S. trade deficit can be partially attributed to the very high prices in the U.S., which are necessary to cover the excessive compensation for executives and other employees at U.S. firms. The high prices in the U.S. encourage firms and consumers to purchase goods from China. Even if China s yuan is revalued upward, this does not necessarily mean that the U.S. firms and consumers will purchase U.S. products. They may shift their purchases from China to purchase products in Indonesia or other low-wage countries rather than buy more products from the U.S. Thus, the underlying dilemma is not China, but any country that has lower costs of production than the U.S. WHO IS CORRECT? Use the Internet to learn more about this issue. Which argument do you support? Offer your own opinion on this issue. ANSWER: The issue is important because it affects the potential degree of economic growth in the U.S. The sustained trade deficit with China may suggest that the yuan is overvalued, but if the yuan is revalued, the U.S. may import more products from other countries where there are low costs of production. Thus, the trade deficit with China may be reduced, but the overall trade deficit may remain. Regardless of any student s opinion, the key is that all students recognize both sides of the issue.

3 Government Influence on Exchange Rates 3 Answers to End of Chapter Questions 1. Exchange Rate Systems. Compare and contrast the fixed, freely floating, and managed float exchange rate systems. What are some advantages and disadvantages of a freely floating exchange rate system versus a fixed exchange rate system? ANSWER: Under a fixed exchange rate system, the governments attempted to maintain exchange rates within 1% of the initially set value (slightly widening the bands in 1971). Under a freely floating system, government intervention would be non-existent. Under a managed float system, governments will allow exchange rates move according to market forces; however, they will intervene when they believe it is necessary. A freely floating system may help correct balance-of-trade deficits since the currency will adjust according to market forces. Also, countries are more insulated from problems of foreign countries under a freely floating exchange rate system. However, a disadvantage of freely floating exchange rates is that firms have to manage their exposure to exchange rate risk. Also, floating rates still can often have a significant adverse impact on a country s unemployment or inflation. 2. Intervention with Euros. Assume that Belgium, one of the European countries that uses the euro as its currency, would prefer that its currency depreciate against the dollar. Can it apply central bank intervention to achieve this objective? Explain. ANSWER: It can not apply intervention on its own because the European Central Bank (ECB) controls the money supply of euros. Belgium is subject to the intervention decisions of the ECB. 3. Direct Intervention. How can a central bank use direct intervention to change the value of a currency? Explain why a central bank may desire to smooth exchange rate movements of its currency. ANSWER: Central banks can use their currency reserves to buy up a specific currency in the foreign exchange market in order to place upward pressure on that currency. Central banks can also attempt to force currency depreciation by flooding the market with that specific currency (selling that currency in the foreign exchange market in exchange for other currencies). Abrupt movements in a currency s value may cause more volatile business cycles, and may cause more concern in financial markets (and therefore more volatility in these markets). Central bank intervention used to smooth exchange rate movements may stabilize the economy and financial markets. 4. Indirect Intervention. How can a central bank use indirect intervention to change the value of a currency? ANSWER: To increase the value of its home currency, a central bank could attempt to increase interest rates, thereby attracting a foreign demand for the home currency to buy high-yield securities. To decrease the value of its home currency, a central bank could attempt to lower interest rates in order to reduce demand for the home currency by foreign investors.

4 4 Government Influence on Exchange Rates 5. Intervention Effects. Assume there is concern that the United States may experience a recession. How should the Federal Reserve influence the dollar to prevent a recession? How might U.S. exporters react to this policy (favorably or unfavorably)? What about U.S. importing firms? ANSWER: The Federal Reserve would normally consider a loose money policy to stimulate the economy. However, to the extent that the policy puts upward pressure on economic growth and inflation, it could weaken the dollar. A weak dollar is expected to favorably affect U.S. exporting firms and adversely affect U.S. importing firms. If the U.S. interest rates rise in response to the possible increase in economic growth and inflation in the U.S., this could offset the downward pressure on the U.S. dollar. In this case, U.S. exporting and importing firms would not be affected as much. 6. Currency Effects on Economy. What is the impact of a weak home currency on the home economy, other things being equal? What is the impact of a strong home currency on the home economy, other things being equal? ANSWER: A weak home currency tends to increase a country s exports and decrease its imports, thereby lowering its unemployment. However, it also can cause higher inflation since there is a reduction in foreign competition (because a weak home currency is not worth much in foreign countries). Thus, local producers can more easily increase prices without concern about pricing themselves out of the market. A strong home currency can keep inflation in the home country low, since it encourages consumers to buy abroad. Local producers must maintain low prices to remain competitive. Also, foreign supplies can be obtained cheaply. This also helps to maintain low inflation. However, a strong home currency can increase unemployment in the home country. This is due to the increase in imports and decrease in exports often associated with a strong home currency (imports become cheaper to that country but the country s exports become more expensive to foreign customers). 7. Feedback Effects. Explain the potential feedback effects of a currency s changing value on inflation. ANSWER: A weak home currency can cause inflation since it tends to reduce foreign competition within any given industry. Higher inflation can weaken the currency further since it encourages consumers to purchase goods abroad (where prices are not inflated). A strong home currency can reduce inflation since it reduces the prices of foreign goods and forces home producers to offer competitive prices. Low inflation, in turn, places upward pressure on the home currency. 8. Indirect Intervention. Why would the Fed s indirect intervention have a stronger impact on some currencies than others? Why would a central bank s indirect intervention have a stronger impact than its direct intervention? ANSWER: Intervention may have a more pronounced impact when the market for a given currency is less active, such that the intervention can jolt the supply and demand conditions more.

5 Government Influence on Exchange Rates 5 A central bank s indirect intervention can affect the factors that influence exchange rates and therefore affect the natural equilibrium exchange rate. Conversely, direct intervention is a superficial method of affecting the demand and supply conditions for a currency, and could be overwhelmed by market forces. 9. Effects on Currencies Tied to the Dollar. The Hong Kong dollar s value is tied to the U.S. dollar. Explain how the following trade patterns would be affected by the appreciation of the Japanese yen against the dollar: (a) Hong Kong exports to Japan and (b) Hong Kong exports to the United States. ANSWER: a. Hong Kong exports to Japan should increase because the yen will have appreciated against the Hong Kong dollar. Therefore, Hong Kong goods will be less expensive to Japanese importers. b. Hong Kong exports to the U.S. should increase because Japanese goods become more expensive to U.S. importers as a result of yen appreciation. Therefore, some U.S. importers may find that even though the exchange rate between the U.S. dollar and Hong Kong dollar is unchanged, the Hong Kong prices are now lower than Japanese prices (from a U.S. perspective). This answer assumes that Japanese exporters did not reduce their prices to compensate U.S. importers for the weaker dollar. If Japanese exporters do reduce their prices to fully offset the effect of the stronger yen, there would be less of a shift to Hong Kong goods. 10. Intervention Effects on Bond Prices. U.S. bond prices are normally inversely related to U.S. inflation. If the Fed planned to use intervention to weaken the dollar, how might bond prices be affected? ANSWER: Expectations of a weak dollar can cause expectations of higher inflation, because a weak dollar places upward pressure on U.S. prices for reasons mentioned in the chapter. Higher inflation tends to place upward pressure on interest rates. Because there is an inverse relationship between interest rates and bond prices, bond prices would be expected to decline. Such an expectation causes bond portfolio managers to liquidate some of their bond holdings, thereby causing bond prices to decline immediately. 11. Direct Intervention in Europe. If most countries in Europe experience a recession, how might the European Central Bank use direct intervention to stimulate economic growth? ANSWER: The ECB could sell euros in the foreign exchange market, which may cause the euro to depreciate against other currencies, and therefore cause an increase in the demand for European imports. 12. Sterilized Intervention. Explain the difference between sterilized and nonsterilized intervention. ANSWER: Sterilized intervention is conducted to ensure no change in the money supply while nonsterilized intervention is conducted without concern about maintaining the same money supply.

6 6 Government Influence on Exchange Rates 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 be likely to adjust their interest rates? How would the currencies of these countries respond to the central bank intervention? 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 intervention? (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 American currencies. 14. Freely Floating Exchange Rates. Should the governments of Asian countries allow their currencies to float freely? What would be the advantages of letting their currencies float freely? What would be the disadvantages? ANSWER: A freely floating currency may allow the exchange rate to adjust to market conditions, which can stabilize flows of funds between countries. If there is a larger amount of funds going out versus coming in, the exchange rate will weaken due to the forces and the flows may change because the currency has become cheaper; this discourages further outflows. Yet, a disadvantage is that speculators may take positions that force a freely floating currency to deviate far from what is perceived to be a desirable exchange rate. 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.

7 Government Influence on Exchange Rates 7 Advanced Questions 16. Monitoring of the Fed s Intervention. Why do foreign market participants attempt to monitor the Fed s direct intervention efforts? How does the Fed attempt to hide its intervention actions? The media frequently reports that the dollar s value strengthened against many currencies in response to the Federal Reserve s plan to increase interest rates. Explain why the dollar s value may change even before the Federal Reserve affects interest rates. ANSWER: Foreign market participants make investment and borrowing decisions that can be influenced by anticipated exchange rate movements and therefore by the Fed s direct intervention efforts. Thus, they may attempt to obtain information from commercial banks about the Fed s intervention actions. The Fed may attempt to disguise its actions by requesting bid and ask quotes on exchange rates, and even mixing some buy orders with sell orders, or vice versa. Foreign exchange market participants may anticipate that once the Fed increases interest rates, there will be an increased demand for dollars, which will result in a stronger dollar. Consequently, they may take positions in dollars immediately, which could place upward pressure on the dollar even before interest rates are affected. 17. Effects of September 11. Within a few days after the September 11, 2001 terrorist attack on the U.S., the Federal Reserve reduced short-term interest rates in the U.S. to stimulate the U.S. economy. How might this action have affected the foreign flow of funds into the U.S. and affected the value of the dollar? How could such an effect on the dollar increase the probability that the U.S. economy would strengthen? ANSWER: The lower interest rates are expected to stimulate the U.S. economy, by encouraging more borrowing and spending. Lower U.S. interest rates may reduce the amount of foreign flows to the U.S., which could have reduced the value of the dollar. If the dollar weakened U.S. exports would be cheaper, which could have increased the demand for products produced by U.S. exporters. 18. Intervention Effects on Corporate Performance. Assume you have a subsidiary in Australia. The subsidiary sells mobile homes to local consumers in Australia, who buy the homes using mostly borrowed funds from local banks. Your subsidiary purchases all of its materials from Hong Kong. The Hong Kong dollar is tied to the U.S. dollar. Your subsidiary borrowed funds from the U.S. parent, and must pay the parent $100,000 in interest each month. Australia has just raised its interest rate in order to boost the value of its currency (Australian dollar, A$). The Australian dollar appreciates against the dollar as a result. Explain whether these actions would increase, reduce, or have no effect on: a. The volume of your subsidiary s sales in Australia (measured in A$), b. The cost to your subsidiary of purchasing materials (measured in A$) c. The cost to your subsidiary of making the interest payments to the U.S. parent (measured in A$). Briefly explain each answer.

8 8 Government Influence on Exchange Rates ANSWER: a. The volume of the sales should decline as the cost to consumers who finance their purchases would rise due to the higher interest rates. b. The cost of purchasing materials should decline because the A$ appreciates against the HK$ as it appreciates against the U.S. dollar. c. The interest expenses should decline because it will take fewer A$ to make the monthly payment of $100, Pegged Currencies. Why do you think a country suddenly decides to peg its currency to the dollar or some other currency? When a currency is unable to maintain the peg, what do you think are the typical forces that break the peg? ANSWER: A country will usually attempt a peg to reduce speculative flows that occur because of exchange rate volatility. It tries to comfort investors by making them believe that the currency will be stable. In some cases, the peg is broken when there are adverse conditions in the country that make investors believe that the peg will be broken. For example, foreign investors become concerned that if the peg breaks, the currency may decline by 20 percent or more against their home currency. This would adversely affect the return on their investment, so they attempt to liquidate their investment and move their fund out of that currency before the peg breaks. If many investors have this concern simultaneously, they are all selling that currency at the same time. They place downward pressure on the currency because there is a larger supply of the currency for sale than the demand for the currency. The central bank may attempt to offset these forces by buying the currency in the foreign exchange market. However, it has a limited amount of that currency as a reserve, and may be overwhelmed by market forces. 20. Impact of Intervention on Currency Option Premiums. Assume that the central bank of the country Zakow periodically intervenes in the foreign exchange market to prevent large upward or downward fluctuations in its currency (the zak) against the U.S. dollar. Today, the central bank announced that it would no longer intervene in the foreign exchange market. The spot rate of the zak against the dollar was not affected by this news. Will the news affect the premium on currency call options that are traded on the zak? Will the news affect the premium on currency put options that are traded on the zak? Explain. ANSWER: It should cause the call option premium and put option premium to increase, because there is more uncertainty surrounding the zak. The seller of a call or put option will require a higher premium on the option, because the seller recognizes that the exchange rate may be more volatile than in the past. 21. Impact of Information on Currency Option Premiums. As of 10:00 a.m., the premium on a specific one-year call option on British pounds is $.04. Assume that the Bank of England had not been intervening in the foreign exchange markets in the last several months. However, it announces at 10:01 a.m. that it will begin to frequently intervene in the foreign exchange market in order to reduce fluctuations in the pound s value against the dollar over the next year, but it will not attempt to push the pound s value higher or lower than what is dictated by market forces. Also, the Bank of

9 Government Influence on Exchange Rates 9 England has no plans to affect economic conditions with this intervention. Most participants who trade currency options did not anticipate this announcement. When they heard the announcement, they expected that the intervention would be successful in achieving its goal. Will this announcement cause the premium on the one-year call option on British pounds to increase, decrease, or to be unaffected? Explain. ANSWER: The premium on the call option should decrease because pound s anticipated volatility should decrease in response to the intervention. 22. Speculating Based on Intervention. Assume that you expect that the European central bank (ECB) plans to engage in central bank intervention in which it plans to use euros to purchase a substantial amount of U.S. dollars in the foreign exchange market over the next month. Assume that this direct intervention is expected to be successful at influencing the exchange rate. a. Would you purchase or sell call options on euros today? b. Would you purchase or sell futures on euros today? ANSWER: a. The intervention should result in a weaker euro, so sell call options on euros today. b. The intervention should result in a weaker euro, so sell futures on euros today. 23. Implications of a Fixed Currency for International Trade. Assume the Hong Kong dollar (HK$) value is tied to the U.S. dollar and will remain tied to the U.S. dollar. Last month, a HK$ = 0.25 Singapore dollars. Today, a HK$=0.30 Singapore dollars. Assume that there is much trade in the computer industry among Singapore, Hong Kong, and the U.S. and that all products are viewed as substitutes for each other and are of about the same quality. Assume that the firms invoice their products in their local currency and do not change their prices. a. Will the computer exports from the U.S. to Hong Kong increase, decrease, or remain the same? Briefly explain. ANSWER: Decrease. The H.K. dollar appreciated against the Singapore dollar while fixed against US dollar, so it should shift purchases to Singapore and away from the US. b. Will the computer exports from Singapore to the U.S. increase, decrease, or remain the same? Briefly explain. ANSWER: Increase. The U.S. dollar appreciated against the Singapore dollar, so it is cheaper to buy goods in Singapore. 24. Implications of a Revised Peg. The country of Zapakar has much international trade with the U.S. and other countries, as it has no significant barriers on trade or capital flows. Many firms in Zapakar export common products (denominated in zaps) that serve as substitutes for products produced in the U.S. and many other countries. Zapakar s currency (called the zap) has been pegged at 8 zaps =$1 for the last several years. Yesterday, the government of Zapakar reset the zap s currency value so that is now pegged at 7 zaps=$1.

10 10 Government Influence on Exchange Rates a. How should this adjustment in the pegged rate against the dollar affect the volume of exports by Zapakar firms to the U.S.? b. Will this adjustment in the pegged rate against the dollar affect the volume of exports by Zapakar firms to non-u.s. countries? If so, explain. c. Assume that the Federal Reserve significantly raises U.S. interest rates today. Do you think Zapakar s interest rate would increase, decrease, or remain the same? ANSWER: a. The zap s value is higher. Demand for Zapakar s exports will be reduced. b. The zap s value is higher against all currencies. The demand for Zapakar s exports by non-u.s. countries will be reduced. c. A rise in the U.S. interest rate will be followed by a rise in Zapakar s interest rate. 25. Pegged Currency and International Trade. Assume that Canada decides to peg its currency (the Canadian dollar) to the U.S. dollar and that the exchange rate will remain fixed. Assume that Canada commonly obtains its imports from the U.S. and Mexico. The U.S. commonly obtains its imports from Canada and Mexico. Mexico commonly obtains its imports from the U.S. and Canada. The traded products are always invoiced in the exporting country s currency. Assume that the Mexican peso appreciates substantially against the U.S. dollar during the next year. a. What is the likely effect (if any) of the peso s exchange rate movement on the volume of Canada s exports to Mexico? Explain. b. What is the likely effect (if any) of the peso s exchange rate movement on the volume of Canada s exports to the U.S.? Explain. ANSWER: a. The peso appreciates against Canadian dollar, so Canadian exports to Mexico should increase. b. The U.S should demand more from Canada (shift away from Mexico), so Canadian exports should increase. 26. Impact of Devaluation. The inflation rate in Yinland was 14% last year. The government of Yinland just devalued its currency (the yin) by 40 % against the dollar. Even though it produces similar types of products as the U.S., it has much trade with the U.S. and very little trade with other countries. It presently has trade restrictions imposed on all non-u.s. countries. Will the devaluation of the yin increase or reduce inflation in Yinland? Briefly explain. ANSWER: The devaluation would increase inflation, because there is no competition from foreign producers. 27. Intervention and Pegged Exchange Rates. Interest rate parity exists and will continue to exist. The one-year interest rates in the U.S. and in the eurozone is 6% and will continue to be 6%. Assume that the country of Latvia's currency (called the Lat) is presently pegged to the euro and will remain pegged to the euro in the future. Assume that you expect that the European central bank (ECB) to engage in central bank intervention in which it plans to use euros to purchase a substantial amount of

11 Government Influence on Exchange Rates 11 U.S. dollars in the foreign exchange market over the next month. Assume that this direct intervention is expected to be successful at influencing the exchange rate. a. Will the spot rate of the Lat against the dollar increase, decrease, or remain the same as a result of central bank intervention? b. Will the forward rate of the euro against the dollar increase, decrease, or remain the same as a result of central bank intervention? c. Would the ECB's intervention be intended to reduce unemployment or reduce inflation in the Eurozone? d. If the ECB decided to use indirect intervention instead of direct intervention to achieve its objective of influencing the exchange rate, would it increase or reduce the interest rate in the Eurozone? e. Based on your answer to part (d), will the interest rate of Latvia increase, decrease, or remain the same as a result of the ECB's indirect intervention? ANSWER: a. The spot rate of the euro will decline, and therefore the spot rate of the Lat will decline as well. b. The forward rate of the euro will decline since it will move in tandem with the spot rate of the euro. c. The intervention is intended to reduce unemployment (weaken currency in order to attract more purchases of its products). d. It could attempt to reduce its interest rate, which reduces the cost of borrowing, and may encourage consumers and firms to borrow more and spend more. e. The interest rate in Latvia would decrease because it would remain consistent with the euro's interest rate since the Lat is pegged to the euro. 28. Pegged Exchange Rates. The U.S., Argentina, and Canada commonly engage in international trade with each other. All the products traded can easily be produced in all three countries. The traded products are always invoiced in the exporting country s currency. Assume that Argentina decides to peg its currency (called the peso) to the U.S. dollar and the exchange rate will remain fixed. Assume that the Canadian dollar appreciates substantially against the U.S. dollar during the next year. a. What is the likely effect (if any) of the Canadian dollar s exchange rate movement over the year on the volume of Argentina's exports to Canada? Briefly explain. b. What is the likely effect (if any) of the Canadian dollar s exchange rate movement on the volume of Argentina s exports to the U.S.? Briefly explain. ANSWER a. The Canadian dollar appreciates against the U.S. dollar, so this means that the Canadian dollar will also appreciate against the peso, which should increase the volume of Argentina s exports to Canada. b. The U.S should demand more from Argentina because imports are now cheaper there as compared to in Canada, so the volume of Argentina's exports to the U.S. would increase.

12 12 Government Influence on Exchange Rates Solution to Continuing Case Problem: Blades, Inc. 1. Did the intervention effort by the Thai government constitute direct or indirect intervention? Explain. ANSWER: The intervention effort by the Thai government constituted direct intervention, since the government exchanged dollar reserves for baht in order to strengthen the currency. This action would increase the demand for baht and the supply of dollars for sale, which puts upward pressure on the baht. In indirect intervention, a central bank attempts to influence the value of a currency by influencing the factors that determine it. For example, if the Thai government wanted to strengthen the baht, it could have increased interest rates by decreasing the Thai money supply. 2. Did the intervention by the Thai government constitute sterilized or nonsterilized intervention? What is the difference between the two types of intervention? Which type do you think would be more effective in increasing the value of the baht? Why? (Hint: Think about the effect of nonsterilized intervention on U.S. interest rates.) ANSWER: The intervention by the Thai government constituted nonsterilized intervention. Using nonsterilized intervention, a central bank intervenes in the foreign exchange market without adjusting for the change in money supply. Using sterilized intervention, a central bank intervenes in the foreign exchange market while retaining the money supply. Since the Thai government exchanged dollar reserves for baht in the foreign exchange market, the dollar money supply is increased. An increase in the money supply may decrease U.S. interest rates, which may additionally weaken the dollar with respect to the baht. Therefore, nonsterilized intervention may compound the desired effects of the intervention effort. If the Thai government s objective is to increase the value of the baht, nonsterilized intervention may be more effective. 3. If the Thai baht is virtually fixed with respect to the dollar, how could this affect U.S. levels of inflation? Do you think these effects on the U.S. economy will be more pronounced for companies such as Blades that operate under trade arrangements involving commitments or for firms that do not? How are companies such as Blades affected by a fixed exchange rate? ANSWER: Under a fixed exchange rate system, inflation may be exported from one country to another. For example, if Thailand experienced relatively high levels of inflation during a fixed exchange rate system, Thai consumers may have switched some of their purchases to U.S. products. Similarly, U.S. consumers may have reduced their imports of Thai goods. This would send Thai production down and unemployment up. Also, it could cause higher inflation in the U.S. due to the excessive demand for U.S. products. Thus, the high inflation in Thailand could cause high inflation in the U.S. For companies such as Blades, this effect would probably be more pronounced as their cost of production would rise, but they export at a fixed price.

13 Government Influence on Exchange Rates What are some of the potential disadvantages for Thai levels of inflation associated with the floating exchange rate system that is now used in Thailand? Do you think Blades contributes to these disadvantages to a great extent? How are companies such as Blades affected by a freely floating exchange rate? ANSWER: A freely floating exchange rate may compound Thailand s inflationary problems. For example, if Thailand experiences high levels of inflation, the baht may weaken. In turn, a weaker baht can cause import prices to be higher, which can increase the prices of Thai materials and supplies and thus increase the price of finished goods. Additionally, higher foreign prices (from the Thai perspective) can force Thai consumers to purchase domestic products. Blades does not contribute to these problems, as both its exports and imports are denominated in baht. Consequently, a weaker baht would have no direct impact on companies importing from Blades. Blades could still be affected by a freely floating exchange rate system, as it is now subject to exchange rate risk when converting the net baht received to dollars. 5. What do you think will happen to the Thai baht s value when the swap arrangement is completed? How will this affect Blades? ANSWER: Under the terms of the agreement, completion of the swap arrangement requires Thailand to reverse the swap of its baht reserves for dollars. Specifically, it will have to exchange dollars for baht at a future date. Due to the decline in the value of the baht, however, Thailand s central bank will need more baht to be exchanged for the dollars needed to repay the other central banks. The purchase of dollars by the Thai government in the foreign exchange market will increase the demand for dollars and the supply of baht for sale, which will put downward pressure on the value of the baht. Since Blades has net inflows in baht, it will be negatively affected by the completion of the swap agreement if the actions needed to complete the agreement result in further weakening of the baht. Solution to Supplemental Case: Hull Importing Company a. Higher interest rates without an increase in inflation would adversely affect Hull, because its expenses would increase, but it would not be able to pass on the higher cost to customers. b. If the British pound s value is increased, Hull s expenses are increased, causing an adverse effect.

14 14 Government Influence on Exchange Rates Small Business Dilemma Assessment of Central Bank Intervention by the Sports Exports Company 1. Forecast whether the British pound will weaken or strengthen based on the information provided. ANSWER: If the Bank of England floods the foreign exchange market with pounds, there will be downward pressure on the value of the pound. However, this pressure could be overwhelmed by other economic forces that place upward pressure on the value of the pound. 2. How would the performance of the Sports Exports Company be affected by the Bank of England s policy of flooding the foreign exchange market with British pounds (assuming that it does not hedge its exchange rate risk)? ANSWER: The performance of the Sports Exports Company would be adversely affected by the Bank of England s policy to flood the foreign exchange market with pounds because this policy places downward pressure on the value of the pound. If the pound weakens, the receivables of the Sports Exports Company will convert to fewer dollars, which reflects a reduction in revenue. ANSWERS TO APPENDIX DISCUSSION QUESTIONS 1. Was the depreciation of the Asian currencies during the Asian crisis due to trade flows or capital flows? Why do think the degree of movement over a short period may depend on whether the reason is trade flows or capital flows? ANSWER: The depreciation of the Asian currencies during the Asian crisis is mostly attributed to the capital outflows from Asia, as investors in Asia and outside of Asia were exchanging the currency for other currencies. Trade flows do not change as abruptly over a short-term period as capital flows, and therefore tend to have a smaller effect over the short-term. 2. Why do you think the Indonesia rupiah was more exposed to an abrupt decline in value than the Japanese yen during the Asian crisis (even if their economies experienced the same degree of weakness)? ANSWER: Investors knew that Indonesia was attempting to use intervention to prevent the rupiah from depreciating. This signaled a potential collapse of the rupiah if and when the government finally surrenders and allows the rupiah to float toward its natural level. 3. During the Asian crisis, direct intervention did not prevent depreciation of currencies. Offer your explanation for why the interventions did not work. ANSWER: Direct intervention can be overwhelmed by market forces, especially when investors are paranoid and want to move their funds out of a country before the local currency weakens.

15 Government Influence on Exchange Rates During the Asian crisis, some of the local firms in Asia borrowed dollars rather than local currency to support local operations. Why would they borrow dollars when they really needed their local currency to support operations? Why did this strategy backfire? ANSWER: They could obtain dollars at a lower interest rate. This strategy backfired because the dollar strengthened against their local currencies. Thus, they had to repay dollar loans with weak currencies, which increased their cost of financing with dollars. 5. The Asian crisis showed that a currency crisis could affect interest rates. Why did the crisis put upward pressure on interest rates in Asian countries? Why did it put downward pressure on U.S. interest rates? ANSWER: The crisis put upward pressure on interest rates because the central banks of these countries attempted to boost the values of the local currencies by using indirect intervention to raise interest rates. 6. It is commonly argued that high interest rates reflect the expectation of high inflation. Based on this theory, how would expectations of Asian exchange rates change after interest rates in Asia increased? Why? Is the underlying reason logical? ANSWER: Higher Asian interest rates could result in weaker Asian currencies, because the high interest rate reflects high expected inflation. One might argue that the underlying reason in this case is not logical if the interest rates were simply pushed up by indirect central bank intervention. That is, the high interest rates may not reflect higher inflation in this case. Nevertheless, there would still be a concern about the capital flows outward if investors become paranoid, and want to move their money out of the country before others do. 7. During the Asian crisis, why did the discount of the forward rate of Asian currencies change? Do you think it increased or decreased? Why? ANSWER: The discount on the forward rate became more pronounced as the Asian interest rates increased. Due to interest rate parity, the larger interest rate gap causes a larger forward discount of the currency with the higher interest rate. 8. During the Hong Kong crisis, the Hong Kong stock market declined substantially over a four-day period due to concerns in the foreign exchange market. Why would stock prices decline due to concerns in the foreign exchange market? Why would some countries be more susceptible to this type of situation than others? ANSWER: The Hong Kong dollar is tied to the U.S. dollar. Yet, if the fixed rate is broken because of excessive Hong Kong dollars for sale, it could cause an abrupt decline in the exchange rate. Some paranoid investors began to sell Hong Kong dollars in exchange for dollars, but Hong Kong was able to use direct intervention to retain the exchange rate. 9. On August 26, 1998, the day that Russia decided to let the ruble float freely, the ruble declined by about 50 percent. N the following day, called bloody Thursday, stock markets around the world (including the U.S.) declined by more than 4 percent. Why do you think the decline in the ruble had

16 16 Government Influence on Exchange Rates such a global impact on stock prices? Was the market s reaction rational? Would the effect have been different if the ruble s plunge had occurred in an earlier time period, such as four years earlier? ANSWER: The decline in the ruble caused general paranoia about a crisis that could be transmitted to other countries. For example, a 50 percent decline in the value of the ruble means that Russian firms may be unable to repay debts denominated in the dollar or other currencies. This could create problems for lenders in those countries, which could result in weak economies. The market reaction to the ruble s plunge was probably more pronounced because it occurred during the Asian crisis when the level of paranoia was already high. 10. Normally, a weak local currency is expected to stimulate the local economy. Yet, it appeared that the weak currencies of Asia adversely affected their economies. Why do you think the weakening of the currencies did not initially improve the economies during the Asian crisis? ANSWER: The weak Asian currencies caused concerns that the firms that borrowed foreign currencies would not be able to repay their debts. In addition, investors expected that the currencies could weaken further, which caused more capital outflows and a lack of funding support in Asia. While non-asian countries may consider purchasing imports in Asia due to the weak currencies, they may be worried that the firms in the Asian countries would go bankrupt and would not be unable to provide the products ordered. 11. During the Asian crisis, Hong Kong and China successfully intervened (by raising their interest rates) to protect their local currencies from depreciating. Nevertheless, these countries were also adversely affected by the Asian crisis. Why do you think the actions to protect the values of their currencies affected these countries economies. Why do you think the weakness of other Asian currencies against the dollar and the stability of the Chinese and Hong Kong currencies against the dollar adversely affected their economies? ANSWER: Since the currencies of China and Hong Kong were tied to the dollar, they appreciated against the other Asian currencies. Thus, their products became more expensive to the other Asian countries, which adversely affected their international trade balance with other Asian countries. 12. Why do you think the values of bonds issued by Asian governments declined during the Asian crisis? Why do you think the values of Latin American bonds declined in response to the Asian crisis? ANSWER: Asian bond prices are influenced by the required rate of return, which is influenced by the market interest rate and the default risk. As interest rates rose, bond prices declined. Also, as the default risk increased, the bond prices declined, as investors would only buy these bonds at a low price. The values of Latin American bonds declined because some investors feared that Latin America would experience the next crisis, which would result in bond defaults. Thus, as the default risk increased, investors would only buy the bonds if the prices were lowered. 13. Why do you think the depreciation of the Asian currencies adversely affected U.S. firms? (There are at least three reasons, each related to a different type of exposure of some U.S. firms to exchange rate risk.)

17 Government Influence on Exchange Rates 17 ANSWER: U.S. firms were adversely affected because their products became more expensive to Asian customers as the dollar strengthened. In addition, U.S. firms with Asian subsidiaries received lower profits as Asian subsidiaries remitted the profits at the weak exchange rate. Third, the consolidated income statement of U.S. firms showed weaker earnings as the earnings earned in Asian subsidiaries was translated at low rates (due to the weakness of Asian currencies), even if the earnings were not remitted to the U.S. 14. During the Asian crisis, the currencies of many Asian countries declined even though their governments attempted to intervene with direct intervention or by raising interest rates. Given that the abrupt depreciation of the currencies was attributed to an abrupt outflow of funds in the financial markets, what alternative Asian government action might have been more successful in preventing a substantial decline in the currencies values? Are there any possible adverse effects of your proposed solution? ANSWER: One solution is to require that capital flows be required to stay within the country for a specific minimum period, such as three months or a year. In this way, funds that enter the country can be used for a longer period of time, and all the funds that enter a country over different points in time would not be allowed to leave the country simultaneously. This would prevent a massive outflow of funds at a single point in time.