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Chaos in The Currency Markets

1. What does the crisis of September 1992 tell you about the relative abilities of currency markets and national governments to influence exchange rates?

The currency markets and national governments both have abilities to influence exchange rates. Like other financial markets, foreign exchange markets react to any news that may have a future effect. Speculators are the part of the currency markets that take currency positions based on anticipated interest rate movements in various countries. Day-to-day speculation on future exchange rate movements is commonly driven by signals of future interest rate movements.

By using the signal, speculators usually take the position before the things actually occurred. Sometime, if high power enough, the speculators position can influence the exchange rate movement. The government controls is one of the factors affecting exchange rate. The government can influence the equilibrium exchange rate in many way, including direct intervening (buying and selling currencies) in the foreign exchange markets and indirect intervening by affecting macro variables such as interest rates.

2. What does the crisis of September 1992 tell you about the weakness of fixed exchange rate regimes?

From European currency crisis of September 1992, it shows us that there are weakness of the fixed exchange rate system. When exchange rate are tied, a high interest rate in one country has a strong influence on interest rates in the other countries. Funds will flow to the country with a more attractive interest rate, which reduces the supply of fund in the other countries and places upward pressure on their interest rates. The flow of fund would continue until the interest rate differential has been eliminated or reduced.

This process would not necessarily apply to countries outside ERM that do not in the fixed exchange rate system, because the exchange rate risk may discourage the flow of funds to the countries with relatively high interest rate. However, since the ERM requires central banks to maintain the exchange rates between currencies within specified boundaries, investors moving funds among the participating European countries are less concerned about exchange rate risk.

3. Assess the impact of the events of September 1992 on the EU ‘s ability to establish a common currency by 1999.

A major concern of a common currency is based on the concept of a single European monetary policy. Each country’s government may prefer to implement its own monetary policy. It would have to adapt to a system in which it had only partial input to the European monetary policy that would be implemented in all European countries, including its own. The system would be alike to that used in the U.S., where there is a single currency across states. Just as the monetary policy in the U.S. cannot be separated across different states, European monetary policy with a single European currency could not be separated across European countries.

While country governments may disagree on the ideal monetary policy to enhance their local economies, they would all have to agree on a single European monetary policy. Any given policy used in a particular period may enhance some countries and adversely affect others. There are some other concerns that could prevent the implementation of a single currency.

For example, at what exchange rate would all currencies be cash in to be exchanged for the common currency to be used? (think about the trouble after reunification of Germany). It would be difficult to reach agreement on this question for each European country’s home currency. Also, some economists believe that changing exchange rates serve as a stabilizer for international trade. Thus, the lack of an exchange rate mechanism could possibly cause greater trade imbalances between countries.

4. The crisis of September 1992 occurred because the ERM system was too inflexible. Discuss.

The inflexible system was not the main reason. The main reason is because there are too different monetary policies among the member of ERM. The German government was more concern about inflation and less concerned about unemployment because its economy was relatively strong. On the other hand, other European governments were more concerned about stimulating their economies to reduce their high unemployment levels. This argument was proved at the end of the crisis when Germany and France s government joined forces to defend the franc against speculative pressure. If all the member joined forces early the crisis may not occur.

5. If you were an executive for a company that engages in substantial intra-EU trade, how would you react to the events of September 1992?

Because the company engages in substantial intra-EU trade, the exchange rate risk is not the major issue-under fixed exchange rate system the exchange rate will fluctuate narrowly. A major concern is the interest rate movement. High interest rate results in high cost of capital to the company and slow growth economic. The problem will even more serious if the company have to pay floated rate liabilities in foreign currencies. The company should consider hedging against interest rate risk such as using interest rate swap or using fixed rate liabilities.

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