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Unit 14: Currency/Forex Market

1. Dollarization: This event occurs when a country decides not to issue its own currency and Notes
adopts a foreign currency as its national currency. Although dollarization usually enables
a country to be seen as a more stable place for investment, the drawback is that the
country’s central bank can no longer print money or make any sort of monetary policy.
An example of dollarization is El Salvador’s use of the U.S. dollar.
2. Pegged Rates: Pegging occurs when one country directly fixes its exchange rate to a foreign
currency so that the country will have somewhat more stability than a normal float. More
specifically, pegging allows a country’s currency to be exchanged at a fixed rate with a
single or a specific basket of foreign currencies. The currency will only fluctuate when the
pegged currencies change.
For example, China pegged its yuan to the U.S. dollar at a rate of 8.28 yuan to US$1,
between 1997 and July 21, 2005. The downside to pegging would be that a currency’s value
is at the mercy of the pegged currency’s economic situation. For example, if the U.S. dollar
appreciates substantially against all other currencies, the yuan would also appreciate,
which may not be what the Chinese central bank wants.
3. Managed Floating Rates: This type of system is created when a currency’s exchange rate is
allowed to freely change in value subject to the market forces of supply and demand.
However, the government or central bank may intervene to stabilize extreme fluctuations
in exchange rates.

Example: For example, if a country’s currency is depreciating far beyond an acceptable
level, the government can raise short-term interest rates. Raising rates should cause the currency
to appreciate slightly; but understand that this is a very simplified example. Central banks
typically employ a number of tools to manage currency.

14.3.2 Market Participants

Unlike the equity market – where investors often only trade with institutional investors (such as
mutual funds) or other individual investors – there are additional participants that trade on the
forex market for entirely different reasons than those on the equity market. Therefore, it is
important to identify and understand the functions and motivations of the main players of the
forex market.

Governments and Central Banks

Arguably, some of the most influential participants involved with currency exchange are the
central banks and federal governments. In most countries, the central bank is an extension of the
government and conducts its policy in tandem with the government. However, some
governments feel that a more independent central bank would be more effective in balancing
the goals of curbing inflation and keeping interest rates low, which tends to increase economic
growth. Regardless of the degree of independence that a central bank possesses, government
representatives typically have regular consultations with central bank representatives to discuss
monetary policy. Thus, central banks and governments are usually on the same page when it
comes to monetary policy.

Central banks are often involved in manipulating reserve volumes in order to meet certain
economic goals. For example, ever since pegging its currency (the yuan) to the U.S. dollar, China
has been buying up millions of dollars worth of U.S. treasury bills in order to keep the yuan at
its target exchange rate. Central banks use the foreign exchange market to adjust their reserve
volumes. With extremely deep pockets, they yield significant influence on the currency markets.

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