Chapter 6

4. 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 float-ing 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 countrys unemployment or inflation.

9. 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 currencys 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.

15. 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.

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 $100,000.

18. Indirect Intervention.

Why would the Feds indirect intervention have a stronger impact on some currencies than others? Why would a central banks 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.

A central banks 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.