Exchange rate systems can be classified according to degree of government control: Fixed Rates: held constant or allowed to fluctuate

within narrow boundaries. Central bank can reset through de/re-valuate (down/up) the value of the currency against others. Advantages: Insulate country from risk of currency appreciation. -Allow firms to engage in direct foreign investment without currency risk. - Allow knowing the future exchange rates. Disadvantages: Risk that government will alter value of currency. -Country and MNC may be more vulnerable to economic conditions in other countries. E.g.Bretton Woods Agreement (1944 1971) Each currency was valued in terms of gold. -Smithsonian Agreement (1971 1973) A devaluation of U.S. currency by 8% against others. Freely floating rates: are determined by market forces without government intervention. Advantages: -Less capital flow restrictions are needed, thus enhancing market efficiency. -Insulation from inflation or economic problems(unemployment) of other countries. -Central bank interventions to control exchange rates within boundaries are not needed. -Governments arent constrained to maintain exchange rates when setting new policies. Disadvantages: Can adversely affect a country that has high unemployment or inflation. -MNCs may devote substantial resources to cope exposure to exchange rate fluctuations. Managed float rates: move freely on a daily basis and no official boundaries exist -Governments sometimes intervene to manipulate their currencies from moving too far in a certain direction to benefit its own country at the expense of others. -Currencies of most large developed countries are allowed to float, although they may be periodically managed by their respective central banks. Pegged: Home currency value is pegged to a foreign currency or an index of currencies -May attract foreign investment because exchange rate is expected to remain stable. -Weak economic or political conditions can cause questions whether the peg will be broken. Examples: Europes Snake Arrangement 1972 1979 European Monetary System (EMS) 1979 1992 Mexicos Pegged System to the U.S. dollar 1994

Chinas Pegged Exchange Rate 1996 2005 Venezuelas Pegged Exchange Rate 2010 Currency Boards: a system for pegging the value of the local currency to some other specified currency must maintain its currency reserves for all currencies that it has printed. Advantages: A board can stabilize a currencys value Disadvantages: Local interest rates must align with interest rates to which the local currency is tied (which may include a risk premium). It is effective only if investors believe it lasts. Dollarization: the replacement of a foreign currency with U.S. dollars. It goes beyond a currency board, as a country no longer has a local currency. Eg Ecuador implemented dollarization in 2000. 1 A Single European Currency: The 1991 Maastricht treaty called for a single currency. By June 2002, currencies of 12 countries* had been withdrawn and replaced with the euro. *Austria, Belgium, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, the Netherlands, Portugal, Spain. European Central Bank: in Frankfurt and is responsible for setting monetary policy for all participating countries. This is to control inflation and stabilize (within reasonable boundaries) the euro value with respect to other major currencies. Impact on Firms Prices of products are easier to compare amongst countries, and encourages more cross-border trade, investments and capital flows. Yet, non-European investors may not achieve as much diversification, in compare to the past. Impact on Financial Bond investors can invest in bonds issued by governments and corporations without concern about exchange rate risk or foreign exchange transaction cost. Exposure of Countries A single European monetary policy prevents any individual country from solving local economic problems with its own unique monetary policy. Any monetary policy may enhance conditions and adversely affect other countries. Impact of Crises may affect the economic conditions of the other participating countries because they all rely on the same currency and same monetary policy. Reasons for Government Intervention 1. If a central bank is concerned that its economy will be affected by abrupt movements in its home currencys value, it may attempt to smooth the currency movements over time. 2. To maintain their home currency rates within some unofficial, implicit, exchange rate boundaries. 3. A central bank may intervene to insulate its currencys value from a temporary disturbance. 4. A central bank may attempt to control the money supply growth in its country. 5. Often overwhelmed by market forces, currency movements are even more volatile without it.

Direct Intervention refers to the exchange of currencies the central bank holds as reserves for other currencies in the foreign exchange market. It is most effective when there is a coordinated effort among central banks, and has high levels of reserves. To force the dollar to depreciate, the Fed intervenes directly by exchanging dollars that it holds as reserves for other foreign currencies. By flooding the market with dollars, the Fed puts downward pressure on the dollar. If the Fed desires to strengthen the dollar, it can exchange foreign currencies for dollars, thereby putting upward pressure on the dollar. The Fed may attempt to increase interest rates (and hence boost the dollars value) by reducing the money supply. Some traders speculate in attempt to determine when Federal Reserve direct intervention is occurring, and the extent of the intervention, in order to capitalize on the anticipated results of the intervention effort. When the Fed intervenes in the foreign exchange market without adjusting for the change in the money supply, it is engaging in a nonsterilized intervention. In a sterilized intervention, the Fed intervenes in the foreign exchange market and simultaneously engages in offsetting transactions in the Treasury securities markets to maintain the money supply. Indirect Intervention: affecting the dollars value by influencing the factors that determine it. - Government Control by increasing or reducing interest rates -Foreign Exchange Controls with restrictions on the exchange of the currency -Intervention Warnings could discourage additional speculation and might even encourage some speculators to unwind (liquidate) their existing positions in the currency.

Intervention as a Policy Tool 1. A weak home currency stimulates foreign demand for products, reduces unemployment, and causes a higher inflation at home. 2. A strong home currency can encourage consumers and corporations of that country to buy goods from other countries. It may lower inflation, since it intensifies foreign competition and forces domestic producers to refrain from increasing prices. It may also lead to higher unemployment. 3. Like tax laws and money supply, the exchange rate is a tool that a government use to achieve its desired economic objectives. Exchange Rate Target Zones have been suggested for reducing exchange rate volatility. An initial exchange rate will be established with specific boundaries. Ideally, the rates will be able to adjust to economic factors without causing fear in financial markets and wide swings in international trade.

Impact of Government Actions on Exchange Rates