Chapter 6

Bretton Woods Agreement 1944-1971

Each currency was valued in terms of gold.

1. What did countries that joined the Euro Single Currency give up in order to join?

Exposure of Countries within the Eurozone · A single European monetary policy prevents any individual European country from solving local economic problems with its own unique currency. · Any given monetary policy used in the eurozone during a particular period may enhance conditions in some countries and adversely affect others. Impact of Crisis within the Eurozone- may affect the economic conditions of the other participating countries because they all rely on the same currency and same monetary policy.

Managed Float Exchange Rate System

· Governments sometimes intervene to prevent their currencies from moving too far in a certain direction. · Countries with floating exchange rates: Currencies of most large developed countries are allowed to float, although they may be periodically managed by their respective central banks. · Criticisms of the managed float system: Critics suggest that managed float allows a government to manipulate exchange rates to benefit its own country at the expense of others.

Pegged Exchange Rate System

· Home currency value is pegged to one foreign currency or to an index of currencies. · Limitations of pegged exchange rate o May attract foreign investment because exchange rate is expected to remain stab le. o Weak economic or political conditions can cause firms and investors to question whether the peg will be broken.

What is the difference between revaluation and appreciation of a currency?

· Revaluation refers to an upward adjustment of the exchange rate by the central bank, whereas the term appreciation refers to the increase in a currency's value that is allowed to fluctuate in response to market conditions.

Indirect Intervention

· The Fed can affect the dollar's value indirectly by influencing the factors that determine it. · Government Control of Interest Rates by increasing or reducing interest rates · Government Use of Foreign Exchange Controls such as restrictions on the exchange of the currency · Intervention Warnings intended to wan speculators. The announcements could discourage additional speculation and might even encourage some speculators to unwind (liquidate their existing positions in the currency.

Direct Intervention

· To force the dollar to weaken, the Fed can intervene directly by exchanging dollars that it holds as reserves for other foreign currencies in the foreign exchange market. · By "flooding the market with dollars" in this manner, the Fed puts downward pressure on the dollar. · If the Fed desires to strengthen the dollar, it can exchange foreign currencies for dollars in the foreign exchange market, thereby putting upward pressure on the dollar.

Nonsterilized versus sterilized intervention

· When the Fed intervenes in the foreign exchange market without adjusting for the change in the money supply, it is engaging in a non-sterilized intervention. · In a sterilized intervention, the Fed intervenes in the foreign exchange market and simultaneously engages in offsetting transactions in the Treasury securities market.

What is the difference between devaluation and depreciation of a currency?

· A central bank's actions to devalue a currency in a fixed exchange rate system are referred to as devaluation. The term depreciation refers to the decrease in a currency's value that is allowed to fluctuate in response to market conditions

1. What are the pros and cons of a strong currency and a weak currency?

· A stronger home currency can encourage consumers and corporations of that country to buy goods from other countries A weaker home currency can stimulate foreign demands for products.

Advantages and disadvantages of free floating exchange rate system

· Advantages of a freely floating system: o Country is more insulated from inflation of other countries. o Country is more insulated from unemployment of other countries. o Does not require central bank to maintain exchange rates within specified boundaries. · Disadvantages of a freely floating exchange rate system: o Can adversely affect a country that has high unemployment. o Can adversely affect a country with high inflation.

Advantages and disadvantages of a fixed exchange rate system

· Advantages of fixed exchange rates o Insulate country from risk of currency appreciation o Allows firms to engage indirect foreign investment without currency risk · Disadvantages of fixed exchange rates o Risk that government will alter value of currency o Country and MNC may be more vulnerable to economic conditions in other countries.

Currency board

· Currency Boards used to Peg Currency values o A system for pegging the value of the local currency to some other specified currency. The board must maintain currency reserves for all the currency that it has printed

Dollarization

· Dollarization: This process is a step beyond a currency board because it forces the local currency to be replaced by the U.S. dollar.

Free Floating Exchange Rate System

· Exchange rates are determined by supply and demand and market conditions without government intervention.

Fixed Exchange Rate System

· Exchange rates are either held constant or allowed to fluctuate only within very narrow boundaries · Central bank can reset a fixed exchange rate by devaluing or reducing the value of the currency against other currencies. · Central bank can also revalue or increase the value of its currency against other currencies

Smithsonian Agreement 1971-1973

called for a devaluation of the U.S. dollar by about 8% against other currencies.