Exchange Rate Movements

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FIN340 304
Tutorial week 3 Questions

1.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..

2. Should the governments of Asian countries allow their currencies to float freely? What would be the advantages of letting their currencies float freely? What would be the disadvantages?

3.What is the impact of a weak home currency on the home economy, other things being equal? What is the impact of a strong home currency on the home economy, other things being equal?

4. Assume the Hong Kong dollar (HK$) value is tied to the U.S. dollar and will remain tied to the U.S. dollar. Last month, a HK$ = 0.25 Singapore dollars. Today, a HK$=0.30 Singapore dollars. Assume that there is much trade in the computer industry among Singapore, Hong Kong, and the U.S. and that all products are viewed as substitutes for each other and are of about the same quality. Assume that the firms invoice their products in their local currency and do not change their prices.

a. Will the computer exports from the U.S. to Hong Kong increase, decrease, or remain the same? Explain.

b. Will the computer exports from Singapore to the U.S. increase, decrease, or remain the same? Explain.

NOTE: Explain in great detail with example and diagram if necessary.
All presentation must be prepared in Power point slide.

1. A) Central Banks can use direct intervention to change the value of currencies. Direct intervention can divide into two parts. It is sterilized intervention and non-sterilized intervention. In the sterilized intervention, Treasury securities are purchased or sold at the same time to maintain the money supply. But non-sterilized intervention is means the central bank intervenes in the foreign exchange market without adjusting for the change in the money supply. Now, we will us an example to illustrated it. Federal Reserve wants to strengthen Candian Dollar(C$). So demand of the C$ will increase, many people will sell US Dollars. Then supply of US Dollar will increase from SS0 to SS1. At that time, supply more than demand, then value of US Dollar will go down from V0to V1. Government doesn’t care about the depreciation of US Dollar. That situation calls non-sterilized intervention. Use the same example above, the only difference is the US government takes the action to prevent the depreciation of US Dollar. When supply of the US Dollars increase, the government also issues the treasury bill to public. Public will pay the US dollar to US government. That will offset the money supply that the government sell the US Dollar in order to buy the C$. Finally, supply of US dollar remains unchanged and value of US dollar is not affected. This is sterilized intervention. Value of US Dollar(US $)

Quantity of US Dollar
SS0
SS1

DD0

V0

V1

Value of US Dollar(US $)
Quantity of US Dollar
SS0
SS1

DD0

V0

V1

We use japan to illustrate the government intervention. Due to the recent instability in Europe, many investors have turned to the Japanese Yen as a safe currency, This sudden flood of increased demand for the Yen is actually hurting Japanese economy. In recent year, Japan faces the serious stagflation problems. Therefore, Japan government intervenes their foreign exchange market to depreciate yen(¥) in order to stimulate their export. They try to use direct intervention to shrink its import deficit. 1.b) Central bank of a country plays crucial role on behalf of the government to intervene in the foreign exchange market to control exchange rate and currency’s value, in addition to regulating the growth of money supply in such a way as to foster economic growth of the country. One of the major reasons for the government intervention is to smooth exchange rate movements. When a central bank feels that abrupt movements in the home currency’s value...
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