BBMF2103 – INTERNATIONAL TRADE FINANCE

TUTORIAL 5

1. a. What are the five basic mechanisms for establishing exchange rates?

The five basic mechanisms for establishing exchange rate are free float, managed float, target-zone
arrangement, fixed-rate system and hybrid system.

1.b. How does each work?

Free float

- Exchange rates are determined by currency supply and demand with no government intervention.

- As economic parameters change, market participants adjust their current and expected future currency
needs.

- Shifts in currency needs in turn shift currency supply and demand.

Managed float

- Central banks intervene to reduce economic volatility,

- Three categories of intervention

● Smoothing out daily fluctuations – central bank buys or sells currency to smooth
exchange rate adjustments. (Eg: gov does not want the currency to fluctuate more than
0.5%, and if it does, gov will intervene)
● Learning against the wind – measures taken to moderate or prevent short- or medium-
term exchange rate fluctuations caused by random events. (Eg: In 2018, Pakistan Harappa
won, creating history to replace BN which has ruled the country for 61 years, demand in
RM dropped due to instability in politic)
● Unofficial pegging – a country pegs the value of its currency to a foreign currency to
protect the value of its exports. (Eg: usually peg against USD, to protect the value)

Target zone arrangement

- Countries agree to adopt economic policies that maintain their exchange rates within a specific range.

- Designed to minimize exchange rate volatility and enhance economic stability in participating
countries.

- Requires coordination of economic policy objectives and practices. Eg: in Euroland (target zone) in
Europe countries will maintain their exchange rate within a specific range.
Fixed rate system

- Governments maintain target exchange rates.

- Central banks buy or sell currency to increase /decrease exchange rates when exchange rates threaten
to deviate from their stated par values by more than an agreed-on percentage.

- Monetary policy becomes subordinate to exchange rate policy.

Hybrid system

- Current international system consisting of free-float, managed-float and pegged currencies.

(Combination of a few systems.)

1.c. What costs and benefits are associated with each mechanism?

Free-Float System:

Benefits:

Flexibility: Governments do not need to intervene in currency markets, which can promote economic
stability and reduce the risk of currency crises.

Auto Adjustment - every currency has its pros and cons. High currency increases standard of living, low
currency motivates the export.

Transparency: The exchange rate is transparent and reflects the true value of the currency.

Costs:

Volatility: Exchange rates in a free-float system can be highly volatile, which may create uncertainty for
businesses and investors. (Difficult for planning and forecasting)

Speculation: Speculative activities can influence exchange rates in the short term, leading to destabilizing
movements.

Managed Float System:

Benefits:

Stability: Managed float systems can provide a degree of stability compared to a free-float system while
still allowing market forces to influence exchange rates.

Costs:

Intervention Risks: Government intervention in currency markets carries the risk of depleting foreign
exchange reserves and may not always be effective in achieving desired outcomes.
Governments run the risk of creating an exchange rate crisis and wasting reserves.

- certain intervention can cause high inflation

- costly and requires a lot of efforts

Target-Zone Arrangement:

Benefits:

minimize exchange rate volatility

enhance economic stability in participating countries.

Stability: Target-zone arrangements set upper and lower bounds for exchange rates, providing a degree of
stability and predictability for businesses and investors.

Flexibility: Within the target zone, exchange rates are allowed to fluctuate based on market conditions,
allowing for some adjustment to economic fundamentals.

Costs:

It requires coordination of policies, objectives and practices which can be difficult to achieve when it
involves so many countries.

- Implementing target zones on a wider scale would be all the more difficult. Differences in preferences,
policy objectives, and economic structures account in part for these difficulties.

- Coordination of macroeconomic policies will not necessarily benefit all participant countries equally,
and those that benefit the most may not be willing to compensate those that benefit least.

Fixed Rate System:

Benefits:

Stability: Fixed exchange rates provide the highest level of stability as the value of the currency is pegged
to another currency or a basket of currencies.

Predictability: Businesses can plan and make decisions with greater certainty about future exchange rate
movements. (Suitable for planning)

Costs:
Loss of Monetary Independence: Countries that adopt a fixed exchange rate regime forfeit independent
monetary policy as they must adjust their domestic policies to maintain the peg.

Hybrid System:

Benefits:

Combination of Benefits: Hybrid systems combine features of multiple exchange rate regimes, allowing
policymakers to tailor the system to their specific economic circumstances.

Costs:

The result can be good or bad.

Complexity: Hybrid systems can be complex to implement and manage, requiring careful coordination
between different policy tools and institutions.

Uncertainty: Market participants may find hybrid systems less predictable than more straightforward
exchange rate regimes, potentially leading to increased uncertainty and volatility.

2. Suppose nations attempt to pursue independent monetary and fiscal policies. How will exchange rates
behave?

Monetary policy refers to central bank activities that are directed toward influencing the quantity of
money and credit in an economy. Three instruments of monetary policy are open market operations,
the discount rate and reserve requirements.

By contrast, Fiscal policy refers to the government's decisions about taxation and spending.

The two sets of policies affect the economy via different mechanisms.

If both work independently without discussion can lead to volatile exchange rate or may offset each other
efforts. By right the government and central bank should discuss and work interdependently to achieve
objective together.

3. The experiences of fixed exchange-rate systems and targetzone arrangements have not been entirely
satisfactory.
 3.a. What lessons can economists draw from the breakdown of the Bretton Woods system?

ANSWER.

Can refer back drawback under fixed rate system in Ques 1c.

The Bretton Wood system, to create fixed international currency exchange rates backed by gold. In a
permanently fixed system, the exchange rate cannot cushion the effects of real economic shocks, such
as devaluation of a major competitor’s currency. Instead, prices must adjust. Given the lack of
flexibility of many prices – because of government regulations or union restrictions – the result of
these economic shocks can be higher unemployment and less economic growth.

Fixed rate system in name only. The basic lesson from Bretton Woods, therefore, is that stabilizing
exchange rates requires dependence and subordination, not the freedom for everybody to do their own
thing. But instead of changing policies to stay with the Bretton Woods system, the major countries simply
dropped the system.

Inflation in the U.S. stemming from the Johnson Administration printing money instead of raising taxes to
finance Viet Nam conflict.

West Germany, Japan, and Switzerland would not accept the inflation that a fixed exchange rate with the
dollar would have imposed on them.

3.b. What lessons can economists draw from the exchange rate experiences of the European
Monetary System?

EMS is the popular eg of targetzone arrangements.

Can refer back drawback under target zone arrangement in Ques 1c.

It requires coordination of policies, objectives and practices which can be difficult to achieve when it
involves so many countries.

- Implementing target zones on a wider scale would be all the more difficult. Differences in preferences,
policy objectives, and economic structures account in part for these difficulties.

- Coordination of macroeconomic policies will not necessarily benefit all participant countries equally,
and those that benefit the most may not be willing to compensate those that benefit least.

In the EMS, Germany is less inflation-prone than the other members and is reluctant to cooperate at the
risk of increasing its inflation rate.
Another lesson is that in target-zone arrangements such as the EMS, a disproportionately large share of
the adjustment burden will fall on the “weak” currency countries. Countries with appreciating currencies,
trade surpluses, and increasing reserves are less prone to adjust than countries with depreciating
currencies, trade deficits, or reserve losses.

Germany, however, has maintained a domestic monetary target of low or zero inflation and has often
refused to alter domestic monetary policy because of exchange rate considerations. Because of
Germany’s economic importance, the other member countries have had to adjust their domestic policies
or their exchange rates to remain competitive in international markets. As a result, inflation rates have
tended to converge toward Germany’s lower rate.
4. What are some indicators of country risk? Of country health?

Can use back answer in Q6

Determinants of a country’s economic performance and degree of risk (S13-17)

Fiscal irresponsibility
Monetary instability
Controlled exchange rate system
Wasteful government spending
Resource base
Adjustment to external shocks

5. What are the common political and economic measures of political stability?

Common political measures of political stability: (Slide9)

- Frequency of changes of government

- Level of violence
- Number of armed insurrection, such as wars or protest like Nigeria, Iraq
- Extent of conflicts with other states

Common economic measures of political stability: (Slide10)

- Inflation
- Balance of payments deficits / surpluses
- Per-capita GDP growth

6. Identify and explain the determinants of a country’s economic performance and degree of risks.

Determinants of a country’s economic performance and degree of risk (S13-17)

Fiscal irresponsibility
Monetary instability
Controlled exchange rate system
Wasteful government spending
Resource base
Adjustment to external shocks

1. Fiscal irresponsibility
Indiscriminant government spending increases country risk. The higher the government deficit as
 a percentage of GDP, the lower the probability a country can meet its obligations without
resorting to expropriations of property, raising taxes, or printing money.

2. Monetary instability
An expansion of the money supply in excess of real output growth results in inflation.

3. Controlled exchange rate system

Currency controls are used to fix the exchange rate and result in an overvalued local currency. An
overvalued currency effectively taxes exports and subsidizes imports.

4. Wasteful government spending

Unproductive spending results in a government having less money to repay its foreign debts. For
instance, instead of use the funds wisely, give politician private Jet, luxury cars, rocket high
salary.

5. Resource base

A country’s resources include natural, human, and financial resources. All things equal, a country
with substantial natural resources is a better economic risk than a country without natural
resources.

6. Adjustment to external shocks

Domestic policies are critical in determining how effectively a country deals with external
shocks. For instance, Asian countries’ policies, characterized by imitation and innovation in the
international market, promoted timely internal and external adjustment.