Reading 17: The Exchange Rate and the Balance of Payments-LOS although, following, 2011, class, exchange

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Session 4: Economics for Valuation
Reading 17: The Exchange Rate and the Balance of Payments

LOS f: Describe the following exchange rate policies: flexible exchange rates, fixed exchange rates, and crawling pegs.

 

 

The Federal Reserve has determined that, although the yen/USD exchange rate is volatile, its equilibrium value is approximately 105 yen/USD. The Fed has decided to intervene in foreign exchange markets to keep the exchange rate in a fairly narrow band around 105 yen/USD. If the exchange rate rises above 110 yen what should the Fed do? If the exchange rate falls below 100 yen what action should the Fed take?

Rise above 110 yen/USD

Fall below 100 yen/USD

A) Buy dollars Sell dollars

B) Buy dollars No action

C) Sell dollars Buy dollars

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If the exchange rate rises above 110 yen /USD the Fed can decrease the rate by selling dollars (supply of USD increases, yen/USD exchange rate falls) and, conversely, if the exchange rate falls below 100 yen/USD, the Fed can increase the rate by selling yen/buying dollars.

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During a recent staff meeting at LeBoeff Financial Capital Inc., Joe Hardy asked the firm’s in-house economist, Robin Heathers, to provide a discussion of the Federal Reserve’s intervention in the foreign exchange markets. At the meeting, Heathers made the following statements:

Statement 1: If the equilibrium dollar-rial exchange rate fluctuates between 150 rial/USD and 180 rial/USD and on average is 165 rial/USD, then the U.S. Fed can reduce exchange rate volatility by buying rials when the rate moves above 175 and selling rials for dollars when the rate moves below 155.

Statement 2: If the average equilibrium exchange rate moves from 165 rial/USD to 175 rial/USD, the U.S. Fed can intervene in the currency markets to return the equilibrium rate to 165.

With respect to these statements:

A) both are incorrect.

B) both are correct.

C) only one is correct.

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The Fed can intervene in the foreign exchange market. The primary reason the Fed would do so is to reduce exchange rate volatility in the short run. So, statement 1 is correct. However, if the underlying equilibrium rial/USD exchange rate increases from 165 to 175, the Fed cannot maintain the exchange rate at 165 rials/USD indefinitely. To do so, the Fed would have to sell dollars and buy foreign currency each day. The Fed would simply be accumulating rials. Eventually, the Fed would have to abandon any attempt to keep the exchange rate at a level different from the long-term equilibrium rate of 175.

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The most likely reason that a central bank would intervene in foreign exchange markets is to:

A) keep the value of the domestic currency high to promote foreign investment.

B) peg the exchange rate at the optimal level.

C) reduce exchange rate volatility.

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A central bank can intervene in foreign exchange markets to reduce volatility but cannot change the underlying equilibrium rate. Attempts to fix the exchange rate at any level different from the underlying equilibrium rate will fail as it would require greater and greater purchases or sales of the foreign currency to maintain a disequilibrium exchange rate. At some point, the central bank would run out of resources to significantly influence exchange rates.

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The benefit of a crawling-peg policy for exchange rates relative to a fixed-rate policy is reduction of risk:

A) in the currency markets.

B) that changes in the inflation rate will cause exchange rates to fluctuate.

C) of the government running out of foreign currency.

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Both fixed-rate and crawling-peg policies are designed to reduce risk in the currency markets. However, when the government periodically resets the rate under a crawling-peg policy, it reduces the risk that it will have too little or too much foreign currency in reserves.