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C1B014024
International Financial Management

Government Influence On Exchange Rates

Exchange rate systems can be classified according to the degree to which the rates are
controlled by the government. Exchange rate systems normally fall into one of the following
categories :
1. Fixed Exchange Rates, In a fixed exchange rate system, the exchange rate between two
currencies is set by government policy. The advantages of fixed exchange rate systems
include the elimination of exchange rate risk, at least in the short run. They also bring
discipline to government monetary and fiscal policies. Disadvantages include lack of
monetary independence and increases in currency speculation regarding possible
revaluations.
2. Freely Floating Rates, A floating exchange rate, or fluctuating exchange rate, is a type of
exchange rate regime wherein a currency's value is allowed to fluctuate according to the
foreign exchange market. The advantages of freely floating exchange rate system is Each
country may become more insulated against the economic problems in other countries,
Central bank interventions that may affect the economy unfavorably are no longer
needed, Governments are not restricted by exchange rate boundaries when setting new
policies, Less capital flow restrictions are needed, thus enhancing the efficiency of the
financial market. And the disadvantages of freely floating exchange rate is MNCs may
need to devote substantial resources to managing their exposure to exchange rate
fluctuations, The country that initially experienced economic problems (such as high
inflation, increasing unemployment rate) may have its problems compounded.
3. Managed Float, is the current international financial environment in which exchange rates
fluctuate from day to day, but central banks attempt to influence their countries' exchange
rates by buying and selling currencies. It is also known as a dirty float.
4. Pegged Exchange Rate System, In a pegged exchange rate system, the home currencys
value is pegged to a foreign currency or to some unit of account, and moves in line with
that currency or unit against other currencies, The European Economic Communitys
snake arrangement (1972-1979) pegged the currencies of member countries within
established limits of each other, The European Monetary System which followed in 1979
held the exchange rates of member countries together within specified limits and also
pegged them to a European Currency Unit (ECU) through the exchange rate mechanism

(ERM), In 1994, Mexicos central bank pegged the peso to the U.S. dollar, but allowed a
band within which the pesos value could fluctuate against the dollar.
Government Intervention, each country has a government agency (called the central
bank) that may intervene in the foreign exchange market to control the value of the countrys
currency.
Direct Intervention :
Through direct intervention in foreign exchange markets, governments are attempting to
offset market forces on spot exchange rates.
a. If market forces strengthen a currency, a government (central bank) could respond
by selling the strong currency (and buying the weak currency) into the foreign
exchange market (thus meeting market demand for the strong currency).
b. If market forces weaken a currency, a government (central bank) could respond by
buying the weak currency (and selling the strong currency) on the foreign exchange
market (thus reducing the supply of the weak currency).
Indirect Intervention :
Indirect intervention generally involves two possible actions:
a. Adjusting domestic interest rates.
Raising interest rates to support a weak currency increasing the interest rate
differential in favor of the weak currency country.
Lowering interest rates to offset a strong currency decreasing the interest
rate differential in favor of the strong currency country.
b. Assumption is that by adjusting the interest rate differential, the demand for the
currency is affected.
c. Problem with interest rate adjustments:
This policy may be inconsistent with domestic economy conditions and
required monetary policy stance for those conditions.