GOVERNMENT INFLUENCE ON EXCHANGE RATES

1. CHAPTER – 6
GOVERNMENT INFLUENCE ON EXCHANGE RATES

2. Exchange Rate Systems
• Exchange rate systems can be classified according to the
degree to which the rates are controlled by the government:
– Fixed
– Freely Floating
– Managed Float
– Pegged

3. Fixed Exchange Rate System
• A fixed exchange rate is a country's exchange rate regime
under which the government or central bank fixed the
exchange rate of foreign currency to home currency.
• Rates are held constant or allowed to fluctuate within very
narrow bands only.
– Devaluation refers to a downward adjustment of the
exchange rate by the central bank.
– Revaluation refers to an upward adjustment of the
exchange rate by the central bank.

4. Benefits of Fixed Exchange Rate System
• Exporters and importers could engage in international trade
without concern about exchange rate movements of the
currency to which their local currency is linked.
• Firms could engage in direct foreign investment, without
concern about exchange rate movements of that currency.
• Investors would be able to invest funds in foreign countries,
without concern about exchange rate movements of that
currency.

5. Disadvantages of Fixed Exchange Rate System
• There is still risk that the government will alter the value of
a specific currency.
• From a macro viewpoint, a fixed exchange rate system may
make each country and its MNCs more vulnerable to
economic conditions in other countries.
– Inflationary Problem
– Unemployment Problem

6. Freely Floating Exchange Rate System
• Rates are determined by market forces without governmental
intervention.
• Freely floating exchange rate system allows complete
flexibility for exchange rate movements.
• A freely floating exchange rate system adjusts on a continual
basis in response to demand and supply conditions for that
currency.

7. • Each country is more insulated from the economic problems of
other countries.
• Central bank is not required to constantly maintain exchange
rates within specified boundaries.
• Governments can implement policies without concern as to
whether the policies will maintain the exchange rates within
specified boundaries.
• Finally, if exchange rates are allowed to float, Less capital flow
restrictions are needed, thus enhancing market efficiency.
Benefits of Freely Floating Exchange Rate System

8. Disadvantages of Freely Floating Exchange
Rate System
• Higher volatility
• Adversely affect a country that initially experienced
the economic problem like inflation.
• Adversely affect a country with high unemployment.

9. Managed Float Exchange Rate System
• Exchange rates are allowed to move freely on a daily
basis and no official boundaries exist. However,
governments may intervene to prevent the rates from
moving too much in a certain direction.
• This type of system is also known as “dirty” float.

10. Pegged Exchange Rate System
• The currency’s value is pegged to a foreign currency or to some
unit of account, and thus moves in line with that currency or unit
against other currencies.
• Some governments peg their currency’s value to that of a stable
currency, such as the dollar, because that forces the value of their
currency to be stable.

11. Overview of Bangladesh
• Historically, Bangladesh had been maintaining various
pegged exchange rate regimes, such as:
– Pegged to pound sterling (£):1972-1979;
– Pegged to a basket of major trading partners' currencies
(£ as the intervening currency) 1980-1982;
– Pegged to a basket of major trading partners' currencies
(US$ as the intervening currency): 1983-1999;
– Crawling band: 2000-2003;
– Floating exchange rate: May 30, 2003- Present.

12. Government Intervention
• Each country has a central bank that may intervene in
the foreign exchange market to control its currency’s
value.
• A central bank may also attempt to control the money
supply growth in its country.

13. • Central banks manage exchange rates
– to smooth exchange rate movements,
– to establish implicit exchange rate boundaries, and
– to respond to temporary disturbances.
Government Intervention