FIN4435Homework2 - Chapter 6 1 Exchange Rate Systems...

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Chapter 6 1. 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 floating 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 country’s unemployment or inflation. 2. Intervention with Euros. Assume that Belgium, one of the European countries that uses the euro as its currency, would prefer that its currency depreciate against the dollar. Can it apply central bank intervention to achieve this objective? Explain. ANSWER: It can not apply intervention on its own because the European Central Bank (ECB) controls the money supply of euros. Belgium is subject to the intervention decisions of the ECB. 3. 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 currency’s 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. 4.
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This note was uploaded on 02/09/2010 for the course FIN 4435 taught by Professor Cheng during the Spring '10 term at Troy Dothan.

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FIN4435Homework2 - Chapter 6 1 Exchange Rate Systems...

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