Question

Although it is a member of the European Community, Denmark is not part of the euro zone; it has its own currency, the krone. Because the krone is pegged to the euro, Denmark's central bank is obliged to maintain the value of the krone within 2.25 percent either above or below the value of the euro. According to a 2017 article in the Wall Street Journal, the Danish central bank was forced to intervene in foreign currency markets "to keep the krone from strengthening too much." a. If the krone was strengthening, did it take more kroner to exchange for a euro or fewer kroner? Briefly explain. b. Given your answer to part (a), was the Danish central bank intervening by buying kroner in exchange for euros or selling kroner in exchange for euros? Briefly explain.

Short answer

In the given scenario when the krone is strengthening: a. It would take fewer kroner to exchange for a euro. b. The Danish central bank would be selling kroner in exchange for euros to reduce the value of the kroner and maintain the peg.

Step-by-step solution

Understand Currency Strength

When a currency 'strengthens', it becomes more valuable compared to another currency. As a result, it will take fewer units of that currency to exchange for one unit of the other currency.

Krone Strengthen Against Euro

So, if the krone was strengthening, it implies that the krone is gaining value relative to the euro. That will mean it takes fewer kroner to exchange for a euro.

Understand Central Bank Intervention

Central banks intervene in foreign currency markets to maintain the value of their currency. This is usually achieved by buying or selling their own currency.

Danish Bank Intervention

If the krone is strengthening too much, the Danish central bank would strive to reduce its value to maintain it within the pegged range. This can be achieved by increasing the supply of kroner in the market, which will decrease its value. The Danish central bank would do this by selling kroner in exchange for euros.

Key concepts

Central Bank Intervention

Central banks play a crucial role in maintaining the stability of a country's currency, especially when it is pegged to another currency such as the euro. When we talk about central bank intervention, we're referring to the efforts made by a country's central bank to buy or sell its own currency in the foreign exchange market to influence its value.
For Denmark, the krone is pegged to the euro, meaning it must remain within a specific range of the euro. If the krone strengthens too much beyond this range, it can harm both Denmark's economy and its trade relations.
To prevent this, the Danish central bank might intervene by increasing the supply of kroner in the market. This is typically done by selling kroner and accumulating foreign currency, like euros. This action generally lowers the krone's value, bringing it back within the pegged range.

• Central banks aim to keep their currency stable against another currency.
• Interventions are strategic actions to counter unwanted fluctuations.
• They maintain economic stability and trade balance.

Foreign Exchange Market

The foreign exchange market, often known as Forex or FX, is a global marketplace where currencies are traded. This market is critical for the conversion of one nation's currency into another and facilitates international trade and investment.
Forex operates 24 hours a day and influences currency valuation through supply and demand dynamics. When a central bank, like Denmark's, intervenes, it does so within this market. The bank's actions, such as buying or selling its currency, can alter the market's supply and demand balance.
In our Denmark example, if kroner is sold by the central bank, the increased supply typically causes a depreciation in its value, aiding in keeping the krone pegged to the euro.

• Forex is the biggest and most liquid financial market.
• Exchange rate fluctuations are influenced by trading volumes.
• Central banks play a role in stabilizing their currency in Forex.

Currency Valuation

Currency valuation refers to determining how much a given currency is worth in terms of another. This involves understanding the relative strength of currencies, which can fluctuate based on various factors such as economic conditions, inflation rates, interest rates, and market speculation.
In the case of the krone's valuation against the euro, its strengthening means the krone becomes more valuable. Fewer kroner are needed to purchase one euro. This change in valuation requires Denmark's central bank to step in, ensuring the krone does not drift too far from its pegged range with the euro.
Understanding currency valuation is essential for the foreign exchange market since it influences trade, investment decisions, and economic policies.

• Currency valuation affects international competitiveness and exports.
• Valuation impacts inflation and purchasing power.
• Central banks monitor and adjust currencies to manage economic impact.