Flexible Exchange Rate

8/11/2019 Flexible Exchange Rate

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CONTENTSPage no

ABSTRACT OF THE PROJECT 2

INTRODUCTION 3

FOREIGN EXCHANGE MARKET 4

EXCHANGE RATE 6

EXCHANGE-RATE REGIME

F!EXIB!E EXCHANGE RATE "3

T#PES OF F!OATING EXCHANGE RATE S#STEM "$

F!OATING EXCHANGE RATE IN ECONOMICS OF THE FOREIGN

EXCHANGE MARKET"6

F!EXIB!E EXCHANGE RATE REGIMES "%

DISTINGUISH BET&EEN F!EXIB!E ' FIXED EXCHANGE RATES 2(

ECONOMIC RATIONA!E 2"

F!OATING EXCHANGE RATE PO!IC# AND MODE!!ING IN INDIA 22

AD)ANTAGES ' DISAD)ANTAGES OF F!EXIB!E EXCHANGE RATES 23

THE BA!ANCE OF PA#MENTS AND EXCHANGE RATES 2*

ARGUMENTS AGAINST F!OATING EXCHANGE RATES 3(

SHIFTING TRENDS 3"

&HAT IS THE FUTURE HO!DS+ 32

INDIAN EXCHANGE RATE REGIME 33

CONC!USIONS 3$

BIB!IOGRAPH# 3*


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ABSTRACT

This Project studies the impact of global financial on

the exchange rate policies(float rate) in emerging

countries. Many emerging countries have loosened

the link of their currencies to the U dollar pillovers

from advanced financial markets to currencies in emerging countries stem from the same causes

documented in the literature on contagion! such as the drying"up of investors# li$uidity! the rise in risk

aversion! and the updating of their risk assessments.

%onse$uently! interdependencies across currencies are likely to be exacerbated during crisis periods. To

test this hypothesis! &e assess the exchange rate policies by their degree of flexibility! itself proxied by

the exchange rate volatility! and investigate their relationship to a global financial stress indicator!

measured by the volatility on global markets. The results confirm that exchange rate flexibility does

increase more than proportionally &ith the global financial stress! for most countries in the sample.


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INTRODUCTION

The exchange rate is a key financial variable that affects decisions made by foreign exchange investors!

exporters! importers! bankers! businesses! financial institutions! policymakers and tourists in the developed as

&ell as developing &orld. 'xchange rate fluctuations affect the value of international investment portfolios!

competitiveness of exports and imports! value of international reserves! currency value of debt payments! and

the cost to tourists in terms of the value of their currency. Movements in exchange rates thus have important

implications for the economy#s business cycle! trade and capital flo&s and are therefore crucial for

understanding financial developments and changes in economic policy.

'very currency area must decide &hat type of exchange rate arrangement to maintain. et&een permanently

fixed and completely flexible ho&ever! are heterogeneous approaches. They have different implications for

the extent to &hich national authorities participate in foreign exchange markets. ccording to their degree of

flexibility! post*retton +oods*exchange rate regimes are arranged into three categories, currency unions!

dollari-ed regimes! currency boards and conventional currency pegs are described as fixed*rate regimes/0

1ori-ontal bands! cra&ling pegs and cra&ling bands are grouped into intermediate regimes/0 Managed and

independent floats are described as flexible regimes. ll monetary regimes except for the permanently fixed

regime experience the time inconsistency problem and exchange rate volatility! albeit to different degrees.

floating exchange rate or fluctuating exchange rate is a type of exchange*rate regime in &hich a currency2s

value is allo&ed to fluctuate according to the foreign*exchange market. currency that uses a floatingexchange rate is kno&n as a floating currency. floating currency is contrasted &ith a fixed currency.

3lexible rates emerge &hen fixed rate systems fail. 4n the 5678#s the failure is centered around fears of

depreciation creating depreciation. 4n the 5698#s the retton +oods system fails in the short run due to

inflation in the U &hich made the dollar a poor choice for an international currency. 1o&ever! flexible

rates create problems as &ell. 4f one country reduces its interest rates! then the exchange rate is likely to

overshoot its eventual decline. The short run drop in the exchange rate and medium term rise allo&s the

interest parity condition to be satisfied. %ountries strongly linked by trade! may &ell try to manage interestrates so that exchange rates do not change too much.

4n the modern &orld! most of the &orld2s currencies are floating0 such currencies include the most &idely

traded currencies, the United tates dollar! the euro! the :or&egian krone! the ;apanese yen! the ritish

pound! the &iss franc! and the ustralian dollar. 1o&ever! central banks often participate in the markets to


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attempt to influence the value of floating exchange rates. The %anadian dollar most closely resembles a

intervene to a greater extent.

3rom 56?@ to the early 5698s! the retton +oods system made fixed currencies the norm0 ho&ever! in 5695!

the U decided no longer to uphold the dollar exchange at 5A7Bth of an ounce of gold! so that the currency

&as no longer fixed. fter the 5697 mithsonian greement! most of the &orld2s currencies follo&ed suit.

1o&ever! some countries! such as most of the Culf tates! fixed their currency to the value of another

currency! &hich has been more recently associated &ith slo&er rates of gro&th. +hen a currency floats!

targets other than the exchange rate itself are used to administer monetary policy (see open*market

operations).

The retton +oods system of monetary management established the rules for commercial and financial

relations among the &orld2s major industrial states in the mid*D8th century. The retton +oods system &as

the first example of a fully negotiated monetary order intended to govern monetary relations among

independent nation*states.

FOREIGN EXCHANGE MARKET

The foreign exchange market (forex! 3E! or currency market) is a global decentrali-ed market for the trading

of currencies. The main participants in this market are the larger international banks. 3inancial centers around

the &orld function as anchors of trading bet&een a &ide range of different types of buyers and sellers around

the clock! &ith the exception of &eekends. 'lectronic roking ervices (') and Feuters 7888 Etra are t&o

main interbank 3E trading platforms. The foreign exchange market determines the relative values of different

currencies.

The foreign exchange market is the market in &hich foreign currencyGsuch as the yen or euro or poundGistraded for domestic currency for example! the U.. dollar. This market/ is not in a centrali-ed location0

instead! it is a decentrali-ed net&ork that is nevertheless highly integrated via modern information and

telecommunications technology.


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The foreign exchange market &orks through financial institutions! and it operates on several levels. ehind

the scenes banks turn to a smaller number of financial firms kno&n as dealers!/ &ho are actively involved in

large $uantities of foreign exchange trading. Most foreign exchange dealers are banks! so this behind*the*

scenes market is sometimes called the interbank market/! although a fe& insurance companies and other

kinds of financial firms are involved. Trades bet&een foreign exchange dealers can be very large! involving

hundreds of millions of dollars. ecause of the sovereignty issue &hen involving t&o currencies! 3orex has

little supervisory entity regulating its actions.

4n the spot market! parties contract for delivery of the foreign exchange immediately. 4n the for&ard market!

they contract for delivery at some point! such as three months! in the future. 4n the option market! they enter a

contract that allo&s one party to buy or sell foreign exchange in the future! but does not re$uire it (thus the

&ord option/). Most of the trading is among banks! either on behalf of customers or on their o&n account.

The counterparty to the transaction could be another dealer! another financial institution! or a nonfinancial

customer. The survey reported that =6 percent of the trading involved the dollar on one side of the transaction

or the other.

The foreign exchange market assists international trade and investment by enabling currency conversion. 3or

example! it permits a business in the United tates to import goods from the 'uropean Union member states!

especially 'uro-one members! and pay euros! even though its income is in United tates dollars. 4t also

supports direct speculation in the value of currencies! and the carry trade! speculation based on the interest

rate differential bet&een t&o currencies. typical foreign exchange transaction! a party purchases some

$uantity of one currency by paying some $uantity of another currency. The modern foreign exchange market

began forming during the 5698s after three decades of government restrictions on foreign exchange

transactions (the retton +oods system of monetary management established the rules for commercial and

financial relations among the &orld2s major industrial states after +orld +ar 44)! &hen countries gradually

s&itched to floating exchange rates from the previous exchange rate regime! &hich remained fixed as per the

retton +oods system.


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THE FOREIGN EXCHANGE MARKET IS UNI,UE BECAUSE OF THE FO!!O&ING

CHARACTERISTICS

4ts huge trading volume representing the largest asset class in the &orld leading to high li$uidity0

its geographical dispersion0

its continuous operation, D? hours a day except &eekends the variety of factors that affect exchange rates0

the lo& margins of relative profit compared &ith other markets of fixed income0 and

the use of leverage to enhance profit and loss margins and &ith respect to account si-e.

s such! it has been referred to as the market closest to the ideal of perfect competition! not&ithstanding

currency intervention by central banks.

'E%1:C' FT'







understanding financial developments and changes in economic policy.







understanding financial developments and changes in economic policy. Timely forecasts of exchange rates

can therefore provide valuable information to decision makers and participants in the spheres of international

finance! trade and policy making.


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+ith liberali-ation and development of foreign exchange and assets markets! variables such as capital flo&s!

volatility in capital flo&s and for&ard premium have also became important in determining exchange rates.

3urthermore! &ith the gro&ing development of foreign exchange markets and a rise in the trading volume in

these markets! the micro level dynamics in foreign exchange markets have increasingly became important in

determining exchange rates. gents in the foreign exchange market have access to private information about

fundamentals or li$uidity! &hich is reflected in the buyingAselling transactions they undertake! that are termed

as order flo&s.

&a. /0 E1ange Ra.e+

Fate at &hich one currency may be converted into another. The exchange rate is used &hen simply

converting one currency to another (such as for the purposes of travel to another country)! or for

engaging in speculation or trading in the foreign exchange market. There are a &ide variety of factors

&hich influence the exchange rate! such as interest rates! inflation! and the state of politics and the

economy in each country. lso called rate of exchange or foreign exchange rate or currency exchange

rate.

4n the foreign exchange market! at a particular time! there exists! not one uni$ue exchange rate! but a variety

of rates! depending upon the credit instruments used in the transfer function. Major types of exchange rates

are as follo&s,

So. Ra.e pot rate of exchange is the rate at &hich foreign exchange is made available on the spot.

4t is also kno&n as cable rate or telegraphic transfer rate because at this rate cable or telegraphic sale

and purchase of foreign exchange can be arranged immediately. pot rate is the day*to*day rate of

exchange.The spot rate is $uoted differently for buyers and sellers. 3or example! H 5 I Fs 5B.B8 for buyers and

H 5 I Fs 5B.78 for the seller. This difference is due to the transport charges! insurance charges!

dealer2s commission! etc. These costs are to be borne by the buyers.

Fo5a57 Ra.e 3or&ard rate of exchange is the rate at &hich the future contract for foreign currency

is made. The for&ard exchange rate is settled no& but the actual sale and purchase of foreign

exchange occurs in future. The for&ard rate is $uoted at a premium or discount over the spot rate.


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!ong Ra.eJong rate of exchange is the rate at &hich a bank purchases or sells foreign currency bills

&hich are payable at a fixed future date. The basis of the long rate of exchange is the interest on the

delayed payment.

The long rate of exchange is calculated by adding premium to the spot rate of exchange in the case of

credit purchase of foreign exchange and deducting premium from the spot rate in the case of credit

sale.

4f the spot rate is K5 I H D.=8 and the rate of interest is @L! then on 78 days bill! H 8.85? &ill be added

per pound in case of credit purchase and deducted in case of credit sale of dollars.

F/1e7 Ra.e3ixed or pegged exchange rate refers to the system in &hich the rate of exchange of a

currency is fixed or pegged in terms of gold or another currency.

F8e1/98e Ra.e3lexible or floating exchange rate refers to the system in &hich the rate of exchange is

determined by the forces of demand and supply in the foreign exchange market. 4t is free to fluctuate

according to the changes in the demand and supply of foreign currency.

M:8./8e Ra.e0 Multiple rates refer to a system in &hich a country adopts more than one rate of

exchange for its currency. ifferent exchange rates are fixed for importers! exporters! and for

different countries.

To-T/e5 Ra.e S;0.e


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The exchange rate is the price of foreign currency. 3or example! the exchange rate bet&een the ritish

pound and the U.. dollar is usually stated in dollars per pound sterling (HAK)0 an increase in this

exchange rate from! say! H5.=8 to say! H5.=7! is a depreciation of the dollar. The exchange rate bet&een

the ;apanese yen and the U.. dollar is usually stated in yen per dollar (NAH)0 an increase in this exchange

rate from! say! N58= to N558 is an appreciation of the dollar. ome countries float/ their exchange rate!

&hich means that the central bank (the country#s monetary authority) does not buy or sell foreign

exchange! and the price is instead determined in the private marketplace. Jike other market prices! the

exchange rate is determined by supply and demands in this case! supplies of and demand for foreign

exchange.

'E%1:C'*FT' F'C4M'

A =e o/n.0


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fundamentals/ are the chief determinant of &hether economic stability and prosperity are achieved! not

the exchange regime per se.

O There is probably no universally optimal/ regime. Fegime choices should reflect the individualproperties and characteristics of an economy.

oth fixed/ and flexible/ regimes have strengths and &eaknesses. fixed exchange rate is generally

seen as being transparent and a simple anchor for monetary policy. %ountries &ith &eak institutions can

import/ monetary credibility by anchoring to a currency &ith a credible central bank. conventional

vie& is that a fixed exchange rate has the advantage of reducing transaction costs and exchange rate risk.

4n countries &ith less developed financial sectors! economic agents may not have the financial tools to

hedge long*term currency risks.

ut adjustments under fixed exchange rates can be very gradual and re$uire significant flexibility in

prices in the domestic economy! especially in the face of changing capital flo&s. The inflexibility of fixed

exchange rates can place an enormous constraint on monetary policy and create pressures in a do&nturn

for pro*cyclical fiscal policies. 3ixed exchange rate regimes in economies &here interest rates are higher

than rates denominated in the anchor currency can also give debtors an incentive to borro& unhedged in

the anchor currency! leaving national balance sheets vulnerable to exchange rate changes. To &ithstand

currency pressures under fixed exchange rate regimes! authorities have an incentive to put in place

harmful capital controls (to be sure! such pressures can exist under flexible regimes as &ell).

country cannot maintain a fixed exchange rate! open capital market! and monetary policy independence

at the same time. 4n recent years more large emerging market countries! increasingly integrated into the

global financial system! have begun to adopt policies that target lo& inflation and establish central bank

independence. 3lexible exchange rates have the advantage that they allo& a country to pursue an

independent monetary policy! rather than have its o&n monetary policy set by an anchor currency

country. 'xperience sho&s that flexible exchange rates are more resilient in the face of shocks! and are


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better able to distribute the burden of adjustment bet&een the external sector and the domestic economy.

lso! fixed exchange rates have the effect of sharply reducing or eliminating exchange rate volatility.

Protection from volatility dampens the incentives for financial markets to develop hedging products and

financial instruments! so risk is more likely to be transferred to the public sector effectively.

gainst this background! exchange regime choices &ill vary.

Ma?o5 C:55en/e0

4t is broadly agreed that the major currencies " the dollar! the euro and the yen " should! and do! float

against one another. The economies represented by these currencies account for ?DL of global economic

activity. :early all global trade and capital flo& transactions are denominated in one of these three

currencies! as are nearly 6BL of official foreign exchange reserves. ther large economies &ith &ell

developed financial sectors! such the U.>.! %anada! or ustralia should! and do! float as &ell.

E


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!oe5-Ino


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F!EXIB!E EXCHANGE RATE

De=/n/./on

country2s exchange rate regime &here its currency is set by the foreign*exchange market through

supply and demand for that particular currency relative to other currencies. Thus! floating exchange rates

change freely and are determined by trading in the forex market. This is in contrast to a


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Under this mechanism! there is a high risk of volatility. ne currency may appreciate or

depreciate steeply! and the exchange rate is similarly affected. This mechanism is called the


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need for government intervention. y contrast! under fixed exchange rates balance of payments

e$uilibrium is not the normal condition.

These characteristics of the floating exchange rate mechanism have important implications both for the

nature of our relationship &ith the global environment! and for the policy options available to the

authorities in managing the economy. Jet us no& consider some of these.

F!EXIB!E EXCHANGE RATE REGIMES

These systems do not particularly reduce time inconsistency problems nor do they offer specific techni$ues

for maintaining lo& exchange rate volatility.

n exchange*rate regime is the &ay an authority manages its currency in relation to other currencies and the

foreign exchange market. 4t is closely related to monetary policy and the t&o are generally dependent on

many of the same factors.

The basic types are a floating exchange rate! &here the market dictates movements in the exchange rate0 a

pegged float! &here a central bank keeps the rate from deviating too far from a target band or value0 and a

fixed exchange rate! &hich ties the currency to another currency! mostly more &idespread currencies such as

the U.. dollar or the euro or a basket of currencies.

F!EXIB!E EXCHANGE RATE REGIMES

A crawling Managed foat

exchange rates

Exchange rate Pure foat


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A 5a8/ng eg attempt to combine flexibility and stability using a rule*based system for gradually

altering the currency2s par value! typically at a predetermined rate or as a function of inflation

differentials. cra&ling peg is similar to a fixed peg! ho&ever it can be adjusted based on clearly

defined rules.ften used by (initially) high*inflation countries or developing nations &ho peg to lo&

inflation countries in attempt to avoid currency appreciation.t the margin a cra&ling peg provides a

target for speculative attacks. mong variants of fixed exchange rates! it imposes the least

restrictions! and may hence yield the smallest credibility benefits. The credibility effect depends on

accompanying institutional measures and record of accomplishment.

E1ange 5a.e 9an70 allo& markets to set rates &ithin a specified range0 endpoints are defended

through intervention. 4t provides a limited role for exchange rate movements to counteract external

shocks &hile partially anchoring expectations. This system does not eliminate exchange rate

uncertainty and thus motivates development of exchange rate risk management tools. n the margin a

band is subject to speculative attacks. 4t does not by itself place hard constraints on policy! and thus

provides only a limited solution to the time inconsistency problem. The credibility effect depends on

accompanying institutional measures! a record of accomplishment and &hether the band is firm or

adjustable! secret or public! band &idth and the strength of the intervention re$uirement.

Manage7 =8oa. e1ange 5a.e0are determined in the foreign exchange market. uthorities can and

do intervene! but are not bound by any intervention rule. ften accompanied by a separate nominal

anchor! such as inflation target. The arrangement provides a &ay to mix market*determined rates &ith


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stabili-ing intervention in a non*rule*based system. 4ts potential dra&backs are that it doesn#t place

hard constraints on monetary and fiscal policy. 4t suffers from uncertainty from reduced credibility!

relying on the credibility of monetary authorities. 4t typically offers limited transparency.

4n a :5e =8oa.! the exchange rate is determined in the market &ithout public sector intervention.

djustments to shocks can take place through exchange rate movements. 4t eliminates the

re$uirement to hold large reserves. 1o&ever! this arrangement does not provide an expectations

anchor. The exchange rate regime itself does not imply any specific restriction on monetary and fiscal

policy.

DISTINGUISH BET&EEN F!EXIB!E EXCHANGE RATE ' FIXED EXCHANGE RATE

F8e1/98e E1ange Ra.e F/1e7 E1ange Ra.e 3lexible 'xchange* Fate ystem allo&s the

exchange rate to be determined by supply

and demand.

The floating exchange rate! in its true form!

allo&s the marketplace to set the rate. The

forces of supply and demand determine the

value of a currency.

The e$uilibrium exchange rate reflects the

3ixed 'xchange Fate is a currency system

in &hich governments try to keep the values

of their currencies constant against one

another

fixed exchange rate is based upon the

government2s vie& of the value of its

currency as &ell as the monetary policy.

Under a fixed*exchange*rate system! a

country2s central bank intervenes by buying


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supply and demand for the currency.

usinesses and individuals cannot plan

their activities &ith the certainty of thevalue of money.

etermined by supply and demand.

4n a floating regime! the central bank may

also intervene &hen it is necessary to

ensure stability and to avoid inflation.

1o&ever! it is less often that the central

bank of a floating regime &ill interfere.

3loating exchange rate is constantly

changing.

or selling its currency to keep its foreign*

exchange rates

usinesses and individuals can plan their

activities &ith the certainty of the value of

money.

The central bank can also adjust the official

exchange rate &hen necessary.

central bank &ill often then be forced to

revalue or devalue the official rate so that

the rate is in line &ith the unofficial one!

thereby halting the activity of the blackmarket.

This is a reserved amount of foreign

currency held by the central bank that it can

use to release (or absorb) extra funds into

the market. This ensures an appropriate

money supply! appropriate fluctuations in

the market (inflationAdeflation) and

ultimately! the exchange rate.

ECONOMIC RATIONA!E

There are economists &ho think that in most circumstances! floating exchange rates are preferable to

fixed exchange rates. s floating exchange rates automatically adjust! they enable a country to dampen

the impact of shocks and foreign business cycles! and to preempt the possibility of having a balance of

payments crisis. 1o&ever! they also engender unpredictability as the result of their dynamism.


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1o&ever! in certain situations! fixed exchange rates may be preferable for their greater stability and

certainty. That may not necessarily be true! considering the results of countries that attempt to keep the

prices of their currency


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4ndia has been operating on a managed floating exchange rate regime from March 5667! marking the start

of an era of a market determined exchange rate regime of the rupee &ith provision for timely intervention

by the central bank5 . 4ndia#s exchange rate policy has evolved overtime in line &ith the global situation

and as a conse$uence to domestic developments. 5665*6D represents a major break in policy &hen 4ndia

harped on reform measures follo&ing the balance of payments crisis and shifted to a market determined

exchange rate system. s has been the experience &ith the exchange rate regimes the &orld over! the

Feserve ank as the central bank of the country has been actively participating in the market dynamics

&ith a vie& to signaling its stance and maintaining orderly conditions in the foreign exchange market.

The broad principles that have guided 4ndia#s exchange rate management have been periodically

articulated in the various Monetary Policy tatements. These include careful monitoring and management

of exchange rates &ith flexibility! no fixed target or a preannounced target or a band and ability to

intervene! if and &hen necessary. ased on the preparedness of the foreign exchange market and 4ndia#s

position on the external front (in terms of reserves! debt! current account deficit etc)! reform measures

have been progressively undertaken to have a liberali-ed exchange and payments system for current and

capital account transactions and further to develop the foreign exchange market.

In.e5en./on

4ntervention by the F4 in the foreign exchange market also plays an important role in influencing

exchange rates in countries that have managed floating regime. +ith the gro&ing importance of capital

flo&s in determining exchange rate movements in most emerging market economies! intervention in

foreign exchange markets by central banks has become necessary from time to time to contain volatility

in foreign exchange markets.

The motive of central bank intervention may be to align the current movement of exchange rates &ith the

long*run e$uilibrium value of exchange rates0 to maintain export competitiveness0 to reduce volatility and

to protect the currency from speculative attacks. Many studies in the literature including 'dison (5667)!

omingue- and 3rankel (5667)! lmenkinders (566B) and more recently arno and Taylor (D885) and

:eely (D88B) survey the literature on modelling the reaction function of the central bank and assessing

the effectiveness of intervention.

4ntervention is of t&o types * sterilised and non*sterilised. 4ntervention is sterilised if the sale or purchase

of foreign currency is accompanied by expansionary or contractionary open market operations! so that

domestic money supply is insulated from the effects of foreign exchange saleApurchase. 4ntervention is


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generally assessed through the for&ard market! and the traders are protected from financial losses

arising from fluctuating exchange rates. This helps in promoting international trade.

In.e5na./ona8 Ine0.


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!o E8a0.//./e0 The elasticities in the international markets are too lo& for exchange rate!

variations to operate successfully in bringing about automatic e$uilibrating adjustments. +hen

import and export elasticities are very lo&! the exchange market becomes unstable. 1ence! the

depreciation of the &eak currency &ould simply tend to &orsen the balance of payments deficit

further.

Un0.a98e on7/./on0 3lexible exchange rates create conditions of instability and uncertainty

&hich! in turn! tend to reduce the volume of international trade and foreign investment. Jong*term

foreign investments arc greatly reduced because of higher risks involved.

A7e50e E==e. on Eono


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situation of high li$uidity preference! people tend to hoard currency! interest rates rise! investment

falls and there is large*scale unemployment in the economy.

In=8a./ona5; E==e. 3lexible exchange rate system involves greater possibility of inflationary

effect of exchange depreciation on domestic price level of a country. 4nflationary rise in prices

leads to further depreciation of the external value of the currency.

Fa.o5 I


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records inflo&s and outflo&s of money for investment and as deposits in banks and other financial

institutions. 4t also includes dealings in the country#s foreign exchange reserves.

The &hole account must balance! but surpluses or deficits can be recorded on any specific part of the

account. Thus the current account could be in deficit but it &ould have to be matched by an e$ual and

opposite capital plus financial account surplus.

The rate of exchange is the rate at &hich one currency exchanges for another. Fates of exchange are

determined by demand and supply in the foreign exchange market. emand for the domestic currency

consists of all the credit items in the balance of payments account. upply consists of all the debit items.

The exchange rate &ill depreciate (fall) if the demand for the domestic currency falls or the supply

increases. These shifts can be caused by a fall in domestic interest rates! higher inflation in the domestic

economy than abroad! a rise in domestic incomes relative to incomes abroad! relative investment

prospects improving abroad! or the belief by speculators that the exchange rate &ill fall. The opposite in

each case &ould cause an appreciation (rise).

The government can attempt to prevent the rate of exchange from falling by central bank purchases of the

domestic currency in the foreign exchange market! either by selling foreign currency reserves or by using

foreign loans. lternatively! the central bank can raise interest rates. The reverse actions can be taken if

the government &ants to prevent the rate from rising.

4n the longer term it can prevent the rate from falling by pursuing deflationary policies! protectionist

policies! or supply*side policies to increase the competitiveness of the country#s exports.

F/1e7 e1ange 5a.e0 95/ng .e a7an.age o= e5.a/n.; =o5 .e 9:0/ne00 o


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F/1e7 e1ange 5a.e0 95/ng .e 7/0a7an.age0 o= on=8/./ng o8/; goa80 .e .en7en; .o 8ea7 .o

o


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%ountries have central banks that try to control the rates of exchange! but often the central banks2 intervention is

not much help. Market forces determine the exchange rates.

ARGUMENTS AGAINST F!OATING

EXCHANGE RATES

Te Ma50a88 !e5ne5 Con7/./on /0 no. nee00a5/8;


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SHIFTING TRENDS

?= countries have hard pegs! @8 countries have soft pegs! and 96 countries have floating ratesGa marked

change from the early 5668s. ince then! there have been t&o broad trends in regimes. The first is the


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This


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The 4ndian exchange rate regime has evolved from an extreme fix to a middle position! but is not yet a

full float. The academic literature has shifted a&ay from advocating corner regimes of a full float or tight

fix for emerging markets to&ards middling regimes. Much market development is re$uired before a full

float becomes feasible. n exchange rate regime must mature and follo& a &ell*se$uenced transition path

The crisis demonstrated that capital flo&s in response to external events created perverse movements in

the exchange rate. o a full float &ith free capital movements need not suit the domestic cycle. 4f capital

flo&s out during a do&nturn the exchange rate depreciates increasing export demand and output0 as

capital flo&s in during an upturn the exchange rate appreciation &ill reduce output thus contributing to

stabili-ation. ut capital moves due to external shocks that may be totally unrelated to domestic

conditions. Moreover! capital movements can be unrelated to fundamentals! sentiment driven! and

excessive.

espite considerable development! 3E markets continue to be thin. o large foreign capital movements

can cause excessive exchange rate fluctuations. 4f a central bank does not buyAsell a currency that is not

freely traded internationally! sharp spikes occur.

'xport competitiveness cannot be ignored &hen the trade deficit is large. Jetting the exchange rate be

driven entirely by volatile capital flo&s! is dangerous. 3ull capital account convertibility and float at the

present juncture &ould be fundamentally unsound.

ut the exchange rate#s potential to reverse their effects on inflation should be acted upon! since

temporary supply shocks occur so often. 4n general! the exchange rate channel of monetary policy

transmission has the shortest lag. 'ven if several policy instruments are used they can be aligned so the

markets get a clear signal on the policy stance. 4n 4ndia convergence of %P4 to +P4 inflation is slo&.

Their differing composition implies a very different impact on each of food price and oil shocks. oengineered policy shocks to the exchange rate! can aid convergence.

The past fe& years have given ample evidence of the impact of the interest rate on aggregate demand.

The steep rise in policy rates prior to Jehman helped cause the crash in industrial output just as the steep


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cut post Jehman led to an unexpectedly fast revival. ince the interest rate is effective so the exchange

rate regime must support a countercyclical interest rate.

ome exchange rate flexibility deepens market and encourages hedging! but excessive change hurts the

real sector. o there should be limits to exchange rate flexibility. &ings beyond a plus minus five

percent invite excessive entry of uninformed traders. ut belo& that level! speculative one*&ay bets on

the exchange rate rise! since the risk in such bets falls. o a ten percent band is the volatility level a

managed float should aim at. There are other factors that have to be kept in mind. The Fupee cannot

appreciate substantially unless the Fimini does so! since %hina is a major trade competitor and partner.

The F4 also has to control for the U factor that can influence &orld macroeconomic variables.

A

F/n7/ng0

The conse$uences of policy choices! and suggest the course of action in the current troubled international

&aters. Points of F4 intervention during crisis outflo&s in D88= slo&ed the depreciation! but it abstained

from the large*scale sale of dollars that could have moderated the depreciation. uch sale &as feasible

given that outflo&s &ere much lo&er than the huge reserves. 4t &as an opportunity to reduce costs of

carrying reserves and to reverse sterili-ation. 4n hindsight sustaining appreciation for the duration of the

supply shocks &ould have been the correct choice since the shocks turned out to be temporary

T&o*&ay movement should apply to reserves alsoGthe latest level should not be seen as a threshold

belo&! &hich they should not fall. ince the exchange rate channel to reduce inflation &as underutili-ed!

excessive reliance &as placed on the interest rate channel! &hich deepened the industrial slo&do&n.

Feducing demand is a costly and inefficient &ay to respond to external cost shocks

The nominal exchange rate has limited influence on the real exchange rate! &hich matters for exports.

1igh domestic inflation appreciates the real exchange rate despite a nominal depreciation. 4f a nominal

appreciation reduces inflation it may reduce real appreciation! and abort real appreciation if it comes from

an external price shock.

short*term nominal appreciation need not harm exporters. large percentage of exporters are naturally

hedged against an appreciating rupee since they import intermediate goods. oft&are exporters! &ho do

not have this advantage! actively hedge currency risk in markets.


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1

4n the longer*run! the real exchange rate must be competitive. 4ndia#s 7@*country real effective rate has

not appreciated much compared to its level in the early nineties. ut if the rise in average &ages exceeds

that in productivity! the level of the real exchange rate consistent &ith lo& inflation may be more

appreciated. ther&ise a nominal depreciation &ill raise imported and domestic food prices! and lo&er

real &ages. ince food is a large share of the domestic consumption basket! nominal &ages &ill

5=rise.This &ill raise prices and appreciate the real exchange rate. nly accepting the real appreciation orraising productivity could break the price*&age cycle. The issue is important given 4ndia#s t&o* year

battle &ith high food prices! rising average &ages! and an expected rise in international food prices.

:ominal overshooting &ill also reduce the pull of the interest differential! &hich is contributing to a

dangerous rise in 4ndia#s short*term debt. 4f the exchange rate overshoots! it is expected to depreciate

lo&ering arbitrage flo&s. f course! this needs to be complemented by strategic use of controls since

higher gro&th in emerging markets and continued accommodated in the +est &ill send large inflo&s into

4ndia.

CONC!USIONS

The paper has concentrated on a number of inflation related issues! in particular! the capacity of a floating

exchange rate to insulate the economy from foreign price shocks! the conse$uences if this does not &ork!

the role of exchange rate targeting in anti*inflationary policy and the appropriate goal for inflation policy.

4n addition! the relation bet&een &ages policy and the depreciation! bet&een the exchange rate and the

current account and the role of exchange market intervention have also been discussed.

ince the float! the country#s economy appears to have independently generated its o&n monetary

conditions and inflation rate. This and other evidence strongly suggests that the float has involved a

reasonable degree of monetary independence and that insulation has &orked. Moreover! in addition to the

standard mechanism of the exchange rate moving to provide insulation from foreign price shocks!

another influence appears to help absorb these shocks. This is the phenomenon of pricing to the market#

&hich enables the smoothing of domestic price movements in importable and exportables.?7 4f there is a

reasonable degree of price insulation there is no need for the authorities to target the exchange rate! for

instance by resisting depreciation! for anti*inflationary purposes. n the other hand! &hen there are


36/38


37/38

1

Te Bo..o< !/ne

lthough the peg has &orked in creating global trade and monetary stability! it &as used only at a time

&hen all the major economies &ere a part of it. +hile a floating regime is not &ithout its fla&s! it has

proven to be a more efficient means of determining the long*term value of a currency and creating

e$uilibrium in the international market.

Boo@0 5e=e55e7

E1ange Ra.e Eono


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http://www.letslearnfnance.com/types-o-oating-exchange-rate-system.html

https://www.im.org/external/pubs/t/andd/2!/"/basics.htm

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http,AA&&&.preservearticles.comAD8585DD65=6=Aadvantages*disadvantages*flexible*exchange*rates.html

http,AAen.&ikipedia.orgA&ikiA'xchange*rateflexibility

http,AAfinancial*dictionary.thefreedictionary.comA3lexibleV'xchangeVFate

http,AA&&&.treasury.govAresource*centerAinternationalAexchange*rate*

policiesAocumentsAppendixD.pdf

http,AA&&&.abc.net.auAmoneyAcurrencyAfeaturesAfeat58.htm

http,AA&&&.slideshare.netA&hatthechuck65Afixed*versus*flexible*exchange*rate*arrangements
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