Jharkhand 4~Exchange Rate Policy
Transcript of Jharkhand 4~Exchange Rate Policy
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REFORM Project, USAID/India
Workshop on Macroeconomic
Aspects
Khwaja M. Sultan
Exchange Rate Policy
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Exchange rate
Nominal exchange rate the rate at which we can trade thecurrency of one country for the currency of another
Real exchange rate the rate at which we can trade the goodsand services of one country with the goods and services of another
Measures the price of a basket of goods and services availabledomestically relative to the same basket available abroad purchasing power parity
Real exchange rate = Nominal exchange rate x Domestic price
Foreign price
{The prices are measured in the respective local currency}
Real exchange rate = (e x P ) / P* e= nominal exchange rate; P = domestic price index; P* = price
index abroad
Shows that nominal exchange rate reflects relative inflation
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Balance of Payment and Exchange Rate
Balance of Payment the record of all transactions of theresidents with the rest of the world
Trade balance Balance of exports and imports of goods exports are positive and imports are negative
Current account balance Balance of trade in goods, (tradebalance), trade in services and transfer payments
Balance in services includes freight, royalty payments, interestpayments, dividend from assets abroad
Transfer payments include remittances, gifts and grants
Capital account balance purchaseand sale of assets stocks, bonds, land purchase by Indians of assets abroad isnegative, purchase of assets by foreigners in India (e.g., FDI) are
positive
Current account + Capital account = 0
Increase in official reserves is called overall BOP surplus
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Terms
Devaluation the price of foreign currencies under afixed exchange rate regime is increased by officialaction
Revaluation - the price of foreign currencies under a
fixed exchange rate regime is decreased by officialaction
Depreciation under a floating rate system, price offoreign currencies decreases because of marketadjustment
Appreciation - under a floating rate system, price offoreign currencies decreases because of marketadjustment
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Fixed Exchange Rate
In a fixed exchange rate system foreign central banks buyand sell their currencies at a fixed price in terms of the domesticcurrency
Prior to 1973, most countries had fixed exchange rates against eachother
A fixed exchange rate acts like a price support system
In order to maintain a fixed exchange rate, the central bank has tomake up for the excess demand or take up the the excess supply offoreign currency.
In order to carry out these interventions, it is necessary for thecentral bank to hold an inventory of foreign currencies.
However, if the country persistently runs deficits in the BOP, thecentral bank eventually runs out of foreign currencies, and will not
be able to carry out the interventions
In such a situation, the central bank will have to ultimately devalue
its currency
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Fixed Exchange Rate
Exchange rate
Quantity of dollars
E1
E2
E
E
EE
E
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Pros and Cons of Fixed Exchange Rate
Argument in favor of fixed exchange rate
CertaintyLess inflationary
Promotes money and capital markets
Helps in the smooth working of the international monetarysystem
Prevents monetary shocks
Argument against fixed exchange rate
Heavy burden on
exchange reserve
Country must have sufficient reserveFails to solve the balance of payment disequilibrium
Does not prevent real shock
It is not a long term solution if the underlying economy is
weak
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Flexible Exchange Rate
In a flexible exchange rate system, the central bank allowsthe exchange rate to adjust toequate the supply and demandfor foreign currency. In effect since 1973
Clean floating the central bank stands aside completely and
allows the exchange rate to be freely determined in the forexmarket official reserve transactions are zero
Managed float - the central bank intervenes to buy or sellforeign currencies periodically in an attempt to influence theexchange rates
Snake in the lake Snake in the tube
Crawling peg
Target zones
Currency board
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Flexible Exchange Rate
Exchange rate
D
Quantity of dollars
S
D1
D2
E
E1
E2
$
$1
$2
$
$
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History of Flexible Exchange Rate
Collapse of the Bretton Woods system in 1971 when the
US Treasury refused to convert short-term liabilities into
gold and made dollar inconvertible 48 countries including the US, Japan, many EU countries
abandoned the fixed exchange rate Group of Ten industrialized countries met at the
Smithsonian Institute in Washington, DC in December
1971; agreed to a new system of stable exchange rate
with wider bands US devalued 8%, Japan revalued17%, Germany revalued 14% - allowed 2.25 %
fluctuation plus/minus;1973 fluctuation widened to 4.5% US devalued again in Feb 1973 Smithsonian
Agreement collapsed
ECU 1979, euro 2001
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Pros and Cons of Flexible Exchange Rate
Argument in favor of flexible exchange rate
Simple operation, smoother, more fluid adjustment Brings realism in forex transactions
Disequilibrium in balance of payment autostabilized
No need for forex reserve to manage exchange rate Prevents real shocks
Reinforces the effectiveness of monetary policy
expansionary
contractionary
Argument against flexible exchange rate
Exchange rate risk futures market Adverse effect of speculation
Encourages inflation
Far from perfect system, but no better system exists
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Linkages between Fiscal Policy and Exchange
Rate
Yincome = Consumption + Investment + Govt + eXport - iMport
Also, Yincome = Consumption + Savings + Taxes
C + S + T = C + I + G + X MS + T = I + G + X M
S + T - I - G = X M
(S - I) + (T - G) = (X - M)
Balancehousehold + Balancegovt. = Balanceforeign
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Foreign Exchange as a Tool of
Monetary Policy
Foreign currency market operations>>>Exchange rate In addition to government bonds, RBI buys and sells foreign currency;
If RBI buys dollars/yen/euros/pounds etc., it increases MS
If RBI sells forex, it decreases MS Buying or selling forex affects the exchange rate
Sterilization Sometimes RBI wants to sell foreign currency to support the rupee, but
does not wish the MS to fall
To do this, RBI uses the rupee it acquires to buy government bonds, thusputting the rupee back into circulation
This process of offsetting foreign exchange market operation with an
open-market operation is called sterilization
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Exchange Rate Adjustments
Automatic adjustments of to correct BOP disequilibriumcan take place through price and income changes, bothunder fixed and flexible exchange regime
Adjustment to external balance needs expenditure-
reducing and expenditure-switching policies
Under fixed exchange rate, automatic adjustmentmechanism works through price and money:unemployment>>fall in prices>>increase in
exports>>gain in employment Price adjustments> increasing the price of imports
through raising tariff now becomes difficult underWTO unless temporary
Income adjustments > contractionary fiscal, wage andmonetary policies
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Exchange Rate Adjustments
ABOP deficit is usually a reflection of monetarydisequilibrium; but the correction mechanism involvesunemployment more painful than devaluation
Monetary expansion, in the long run, increases price
level and exchange rate, keeping terms of trade and realbalance constant
In the short run, monetary expansion increases outputand reduces interest rates, depreciating the currency
Government can intervene in exchange rate markets tolimit the impact of exchange rate fluctuation on outputand prices
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Exchange Rate Policy Synchronization
If policies are not synchronized between countries, theymay pose a major threat to free trade
When import prices fall due to currency appreciation,large shifts in demand will occur domestic workers
become unemployed leads to pressure for protection tariff and quotas
Flexible exchange regime calls for more interdependencethan fixed exchange rate.
Through international coordination of interests andpolicies, the system works better
Regular consultation between major currencies
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Indias Exchange Rate Experience
In 1972, when the pound was floated, the rupee kept parity with theBritish pound
Between 1975 and 1991 India followed the basket of currencysystem, with the British pound as the currency of intervention
This was a managed float with a margin of +/- 5 percent with a
discretionary crawling peg The basket peg reduced exchange risks compared to the earlier
pound peg, but did not eliminate the risk
In 1991, during the BOP crisis, the RBI brought about a sizeabledownward adjustment of the rupee value
LERMS Liberalized Exchange Rate Management System 50%of the currency was freely convertible at market exchange rate, and50% under a managed float
1993 Unified Exchange Rate System
Convertibility of the rupee under current account
No full convertibility and capital account convertibility
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Asian Crisis of 1997
In the spring of 1997, there was the start of the economic crisis
High growth, high export, high investment, large ST borrowings
Crisis triggered by sharp fall in export growth in 1996 ofsemiconductors (a major item of export from the region)
Adversely affected the confidence of ST lenders who pulled out Rapid outflow of private capital resulting in rapid devaluation and
fall in stock market
One after another, countries were forced to devalue their currencies
The crisis spread to Eastern Europe and Russia
Banks were shut down , stock markets dropped steeply Both troubled and sound Asian economies were swept up in the
contagion. Fears of a worldwide depression loomed
By 1990, most of the economies were back on track
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Lessons Learned
Asian economies reaped immense benefits from globalization
Achieved huge growth
However the financial sector did not have necessary safeguards
Rapid expansion of credit during 1994-97, including high-risklending by banks
The bulk of capital inflow initially went into manufacturing andinfrastructure, but later large speculative investments were made inreal estate, stock purchase and consumer creidt
Banks did not have adequate financial supervisory and regulatorysystem keeping pace with the change in global capital flows
Falling assets price exposed the weakness of the financial system
India remained largely unaffected
Prudential norms and improved asset classification and accountingpractices were introduced
Very little exposure to real estate by Indian banks
Public sector ownership and trade unions reduce efficiency
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Latin American Crises
In mid 1980s hyperinflation hit Israel and many Latin Americancountries (Argentina and Brazil)
Using a heterodox approach, monetary, exchange rate and fiscalpolicies were used with income policies wages and prices werefrozen. That stopped inflation
The stabilization succeeded in Israel because it corrected its fiscaldeficit, whereas it did not succeed in Latin America where the fiscalcorrection was not sustained.
Wage and price control alone cannot hold inflation under check ifthe underlying fundamentals of fiscal and monetary policy are notconsistent with low inflation.
Mexico had borrowed too much in the 1980s from the worldmarkets. Under great pressure because of high interest rates of the1980s.
Crisis emerged when foreign lenders lost confidence in Mexico.Huge financing gap emerged.
Ended in major devaluation and deep depression
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Latin American Crises
In 1994 and 1995, Mexico underwent a major devaluation from 30cents to a peso to 15 cents to a peso
The need for a policy change was predicted well in advance
Argentina had perpetual currency mismanagement
55 governors of central bank in 55 years
Ten different monies in succession
In 1990 Argentina chose the currency board system , whichprovides the local currency with 100 percent backing in foreignreserves
As a result no discretion for central bank to print money to finance
budget deficit
But public finance and property rights continued to malfunction
As a result the currency board system crashed and Argentina had todevalue again