Module 1

Session 5: Government Influence

on Exchange Rates
Session Overview

A. Exchange Rate Systems

B. Government Intervention

C. Intervention as a Policy Tool

Session Objectives

A. Describe the exchange rate system used by

various governments
B. Explain how governments can use direct
intervention to influence exchange rates
C. Explain how governments can use indirect
intervention to influence exchange rates
D. Explain how government intervention in the
foreign exchange market can affect economic
conditions
A. Exchange Rate Systems

1. Fixed Exchange Rate System

a. Bretton woods Agreement

b. Smithsonian Agreement
c. Advantages of a Fixed Exchange
Rate System
d. Disadvantages of a Fixed Exchange
Rate System
A. Exchange Rate Systems
2. Freely Floating Exchange Rate System
a. Advantages of a Freely Floating Exchange Rate
System
1.) a country is more insulated from the inflation of
other countries
2.) a country is more insulated
from unemployment problems in other countries

b. Disadvantages of a Freely Floating Exchange Rate System

can adversely affect a country that has high unemployment.
A. Exchange Rate Systems

3. Managed Float Exchange Rate System

a. Criticism of a Managed Float
System
A. Exchange Rate Systems
4. Pegged Exchange Rate System
a. Limitations of a Pegged System
b. Creation of Europe’s Snake
Arrangement
c. Creation of the European Monetary
System (EMS)
d. Demise of the European Monetary
System
A. Exchange Rate Systems

5. Currency Boards
a. Exposure of a Pegged Currency
to Interest Rate Movements

b. Exposure of a Pegged
Currency to Exchange Rate
Movements
A. Exchange Rate Systems
6. Dollarization
a. the replacement of a foreign currency withU.S.
dollars.

b. This process is a step beyond a currency board

because it forces the local currency to be replaced by
the U.S. dollar.

c. Although dollarization and a currency board both

attempt to peg the local currency’s value, the currency
board does not replace the local currency with dollars.

7. Classification of Exchange Rate Arrangements

C. Government Intervention

1. Reasons for Government Intervention

a. Smooth Exchange Rate
Movements
b. Establish Implicit Exchange Rate
boundaries
c. Respond to Temporary
Disturbances
Effects of Direct Central Bank Intervention
in the Foreign Exchange Market

Exhibit 6.2
C. Government Intervention
2. Direct Intervention
a. Reliance on Reserves
b. Speculating on Direct Intervention
3. Indirect Intervention
a. Government Adjustment of Interest
Rates
b. Government Use of Foreign Exchange
Controls
D. Intervention as a Policy Tool

1. Influence of a Weak Home Currency on

the Economy

2. Influence of a Strong Home

Currency on the Economy