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Unformatted text preview: Chapter 6 GOVERNMENT INTERVENTION ON FOREIGN EXCHANGE RATE a) Exchange Rate System a.i. Fixed a.ii. Freely floatingin the value of a currency a.iii. Managed float a.iv. Pegged Answers: i) Fixed Exchange Rate System- exchange rates are constant or allowed to fluctuate only within very narrow boundaries.- requires much central bank intervention in order to maintain a currency’s value within boundaries.- the central bank has to offset any imbalance between demand and supply conditions for its currency in order to prevent its value from changing.- a central bank may reset a fixed exchange rate.- a central bank’s action to devalue or reduce the value of its currency against other currencies which referred to as devaluation, - depreciation : (1) describing the decrease in values of currencies that are not subject to a fixed rate system. (2) represents the decrease in the value of a currency.- a central bank may revalue or increase the value of its currency against other currencies which referred to as revaluation .- appreciation : (1) describing the increase in values of currencies that are not subject to a fixed exchange rate system. (2) represents the increase in the value of a currency that is allowed to change in response to market conditions.- Advantages of fixed exchange rate: (1) Reduced risk in international trade - By maintaining a fixed rate, buyers and sellers of goods internationally can agree a price and not be subject to the risk of later changes in the exchange rate before contracts are settled. The greater certainty should help encourage investment. (2 ) Introduces discipline in economic management - As the burden or pain of adjustment to equilibrium is thrown onto the domestic economy then governments have a built-in incentive not to follow inflationary policies. If they do, then unemployment and balance of payments problems are certain to result as the economy becomes uncompetitive. (3) Fixed rates should eliminate destabilizing speculation - Speculation flows can be very destabilizing for an economy and the incentive to speculate is very small when the exchange rate is fixed.-Disadvantages of fixed exchange rate (1) No automatic balance of payments adjustment - A floating exchange rate should deal with disequilibrium in the balance of payments without government interference, and with no effect on the domestic economy. If there is a deficit then the currency falls making you competitive again. However, with a fixed rate, the problem would have to be solved by a reduction in the level of aggregate demand. As demand drops people consume less imports and also the price level falls making you more competitive. (2) Large holdings of foreign exchange reserves required - Fixed exchange rates require a government to hold large scale reserves of foreign currency to maintain the fixed rate - such reserves have an opportunity cost....
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This note was uploaded on 10/28/2011 for the course FINANCE 101 taught by Professor Profshamsul during the Spring '11 term at International Islamic University Malaysia.
- Spring '11
- Exchange Rate