Submitted to :prof: Meghna chabbra

Government influence on

Exchange Rate

Submitted by :Nitesh daga,Shweta Ghanshani,Anupam Dubey

Presentation On :

Objectives To describe the exchange rate systems used

by various governments;

To explain how governments can use direct and indirect intervention to influence exchange rates; and

To explain how government intervention in the foreign exchange market can affect economic conditions.

Exchange Rate Regimes

• Fixed exchange rate regime– Value of a currency is pegged relative to the

value of one other currency (anchor currency)

• Floating exchange rate regime– Value of a currency is allowed to fluctuate against

all other currencies

• Managed float regime (dirty float)– Attempt to influence exchange rates by buying

and selling currencies

Past Exchange Rate Regimes• Gold standard

– Fixed exchange rates– No control over monetary policy– Influenced heavily by production of gold and

gold discoveries

• Bretton Woods System– Fixed exchange rates using U.S. dollar as

reserve currency– International Monetary Fund (IMF)– World Bank– General Agreement on Tariffs and Trade (GATT)

• World Trade Organization

• European Monetary System– Exchange rate mechanism

How a Fixed Exchange Rate Regime Works

• When the domestic currency is overvalued, the central bank must purchase domestic currency to keep the exchange rate fixed, but as a result, it loses international reserves

• When the domestic currency is undervalued, the central bank must sell domestic currency to keep the exchange rate fixed, but as a result, it gains international reserves

• Expl: Bretton Woods Era (1944-1971), Smithsonian Agreement (1971)

A little more about Bretton Woods System

• Feature: an obligation for each country to adopt a monetary policy that maintained the exchange rate of its currency within a fixed value—plus or minus one percent—in terms of gold and the ability of the IMF to bridge temporary imbalances of payments

– Exchange rate stability was a prime goal - Fixed exchange rates using U.S. dollar as reserve currency

– Setting up a system of rules, institutions, &procedures to regulate the international monetary system, through the IMF and the IBRD, which today is part of the World bank group. They became operational in 1945 after a sufficient number of countries had ratified the agreement.

Bretton Woods System…….

• What emerged was the “Pegged Rate" currency regime. Members were required to establish a parity of their national currencies in terms of gold (a "peg") and to maintain exchange rates within plus or minus 1% of parity (a "band") by intervening in their foreign exchange markets (that is, buying or selling foreign money).

Reality of the Bretton Woods System• Adjustable pegs was almost never adjusted• IMF monitoring was ineffectual (when nations adjusted

exchange rates, they did not follow the rules)• Inflation was a persistent problem, beginning in the

1960s (with the US was the biggest offender)• Bretton Woods collapsed abruptly in 1971 – Nixon

breaks the link between dollar and gold

Bretton Woods System…….What caused the breakdown of Bretton

Woods?

1. Rising capital mobility– Markets inevitably recover from WWII– Domestic financial deregulation made it harder to stop

capital flows at the border E.g., the rise of Eurodollar market, in which dollar

denominated assets were traded in Europe• The combined effect was to heighten the conflict between

domestic and external goals

2. Lack of Monetary Discipline in the U.S.• US money supply and budget deficit grew, reflecting Great

Society and Vietnam War pressures• Fundamental unwillingness to cut spending and/or reduce

inflation

System: Rates are held constant or allowed to fluctuate within very narrow bands only.

Adv:• MNCs know the future exchange rates.Disadv:Governments can revalue their

currencies.Each country is also vulnerable to the

economic conditions in other countries.

Fixed Exchange Rate System

To improve a poor macroeconomic situation, a country increases its money supply so that banks are more willing to lend.

Interest rate drops

Real spending, production, and income rise, but

Capital flows out.

((in the short run)

The Current account balance “worsens” as exports fall and imports increase.

The overall payments balance “worsens.”

The price level increases.

Expanding the Money Supply Worsens the Balance of PaymentsExpanding the Money Supply Worsens the Balance of Payments

Monetary Policy with Fixed Exchange RatesMonetary Policy with Fixed Exchange Rates

System: Rates are determined by market forces without governmental intervention.

Each country is more insulated from the economic problems of other countries.

Central bank interventions just to control exchange rates are not needed.

Governments are not constrained by the need to maintain exchange rates when setting new policies.

Freely Floating Exchange Rate System

Less capital flow restrictions are needed, thus enhancing market efficiency.

MNCs may need to devote substantial resources to managing their exposure to exchange rate fluctuations.

The country that initially experienced economic problems (such as high inflation, increased unemployment) may have its problems compounded.

Freely FloatingExchange Rate System

Managed Float• Hybrid of fixed and flexible

– Small daily changes in response to market– Interventions to prevent large fluctuations

• Appreciation hurts exporters and employment

• Depreciation hurts imports and stimulates inflation

• Special drawing rights as substitute for gold

System: Exchange rates are allowed to move freely on a daily basis and no official boundaries exist. However, governments may intervene to prevent the rates from moving too much in a certain direction.

A government may manipulate its exchange rates such that its own country benefits at the expense of other countries.

Managed FloatExchange Rate System

With an With an increase in the increase in the money supply, money supply, banks are banks are more willing more willing to lend.to lend.

Interest Interest rate rate dropsdrops

Real spending, Real spending, production, and production, and income rise.income rise.

Capital flows out.Capital flows out.

(In the short run)(In the short run)

Current account Current account balance “worsensbalance “worsens.”.”

Currency Currency depreciation and depreciation and automatic automatic adjustment begins!adjustment begins!

The Price level The Price level increases.increases.

Effects of Expanding the Money SupplyEffects of Expanding the Money Supply

The The Current Current account account balance balance improvesimproves

Real Real product product and and income income rise morerise more

((Beyond the short run)Beyond the short run)

Monetary Policy with Floating Exchange RatesMonetary Policy with Floating Exchange Rates

System: The currency’s value is pegged to a foreign currency or to some unit of account, and thus moves in line with that currency or unit against other currencies

Examples: European Economic Community’s snake* arrangement (1972), European Monetary System’s exchange rate mechanism (1979), Mexican peso’s peg to the U.S. dollar (1994)

PeggedExchange Rate System

Snake Arrangement• The snake in the tunnel was the first

attempt at European monetary cooperation in the 1970s, aiming at limiting fluctuations between different European currencies.

• It was an attempt at creating a single currency band for the EEC, essentially pegging all the EEC currencies to one another.

Currency Boards• A currency board is a monetary authority which

is required to maintain a fixed exchange rate with a foreign currency.

• This policy objective requires the conventional objectives of a central bank to be subordinated to the exchange rate target.

• Money supply can expand only when foreign currency is exchanged for domestic currency

• Stronger commitment by central bank

• Loss of independent monetary policy and increased exposure to shock from anchor country

• Loss of ability to create money and act as lender of last resort

Currency Boards• A currency board is a system for

pegging the value of the local currency to some other specified currency.

Examples: HK$7.80 = US$1 (since 1983), 8.75 El Salvador colons = US$1 (2000)A board can stabilize a currency’s value. It is effective only if investors believe that it

will last.

Currency BoardsLocal interest rates must be aligned

with the interest rates of the currency to which the local currency is tied.Note: The local rates may include a risk

premium.

A currency that is pegged to another currency will have to move in tandem with that currency against all other currencies.

Dollarization• Another solution to lack of transparency and

commitment• Adoption of another country’s money (replacement

of a foreign currency with U.S. dollars). Dollarization goes beyond a currency board, as the country no longer has a local currency i.e. Ecuador implemented dollarization in 2000.

• Even stronger commitment mechanism• Completely avoids possibility of speculative attack

on domestic currency• Lost of independent monetary policy and increased

exposure to shocks from anchor country• Inability to create money and act as lender

of last resort

Exchange Rate Arrangements

Pegged Rate System:Bahamas Bermuda Hong KongBarbados China Saudi Arabia

Pegged to U.S. dollar

Floating Rate System:Afghanistan Hungary Paraguay SwedenArgentina India Peru SwitzerlandAustralia Indonesia Poland TaiwanBolivia Israel Romania ThailandBrazil Jamaica Russia United Kingdom

Canada Japan Singapore VenezuelaChile Mexico South Africa

Euro countries Norway South Korea

A Single European Currency

• The 1991 Maastricht treaty called for a single European currency – the euro.

• The euro (€) is the official currency of the EU, and is currently in use in 16 of the 27 member states

• The states, known collectively as the Eurozone, are Austria, Belgium, Cyprus, Finland, France, Germany, Greece, Ireland, Italy, Luxembourg, Malta, the Netherlands, Portugal, Slovakia, Slovenia and Spain

• The Frankfurt-based European Central Bank is responsible for setting European monetary policy, which is now consolidated because of the single money supply.

• Each participating country can still rely on its own fiscal policy (tax and government expenditure decisions) to help solve its local economic problems.

A Single European Currency

Government Intervention• Each country has a central bank that may

intervene in the foreign exchange market to control its currency’s value.

• Central banks manage exchange rates– to smooth exchange rate movements,– to establish implicit exchange rate

boundaries, and– to respond to temporary disturbances.

• Often, intervention is overwhelmed by market forces. However, currency movements may be even more volatile in the absence of intervention.

• Direct intervention refers to the exchange of currencies that the central bank holds as reserves for other currencies in the foreign exchange market.

• Direct intervention is usually most effective when there is a coordinated effort among central banks and when the central banks have high levels of reserves that they can use.

Government Intervention

D2

Quantity of $

S1

D1

Valueof $

V1

V2

RBI exchanges Rs for $to strengthen the $

S2

RBI exchanges $ for Rsto weaken the $

V2

Quantity of $

D1

Valueof $

V1

S1

Effects of Direct Central Bank Intervention

in the Foreign Exchange Market

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,

thus putting the rupee back into circulation This process of offsetting foreign exchange market operation with an

open-market operation is called sterilization

• When a central bank intervenes in the foreign exchange market without adjusting for the change in money supply, it is said to engage in non-sterilized intervention

• Here the domestic currency is sold to purchase foreign assets leads to a gain in international reserves, an increase in the money supply, and a depreciation of the domestic currency

Government Intervention Non-sterilized Intervention

Non-sterilized Foreign Exchange Intervention

• A central bank’s purchase of domestic currency and corresponding sale of foreign assets in the foreign exchange market leads to an equal decline in its international reserves and the monetary base

• A central bank’s sale of domestic currency to purchase foreign assets in the foreign exchange market results in an equal rise in its international reserves and the monetary base

Central Bank Reserve System Central Bank Reserve System

Assets Liabilities Assets Liabilities

Foreign Assets

-$1B Currency in circulation

-$1B Foreign Assets

-$1B Deposits with the RBI

-$1B

(International Reserves)

(International Reserves)

(reserves)

Sterilized intervention

• In a sterilized intervention, the central bank simultaneously engages in offsetting transactions in the Treasury securities markets to maintain the money supply.

Sterilized Foreign Exchange

Intervention

• To counter the effect of the foreign exchange intervention, conduct an offsetting open market operation

• There is no effect on the monetary base and no effect on the exchange rate

Central Bank Reserve System

Assets Liabilities

Foreign Assets Monetary Base

(International Reserves)

-$1B (reserves) 0

Government Bonds +$1B

RBI Reserve

Banks participatingin the foreign

exchange market

Rs $To Strengthen

the $:

Rs

RBI Reserve

Banks participatingin the foreign

exchange market

$To Weaken the $:

Financialinstitutionsthat investin Treasurysecurities

Rs

T- securities

Financialinstitutionsthat investin Treasurysecurities

Rs

T- securities

Non-sterilized versus Sterilized Intervention

Nonsterilized Sterilized

• Some speculators attempt to determine when the central bank is intervening directly, and the extent of the intervention, in order to capitalize on the anticipated results of the intervention effort.

• Central banks can also engage in indirect intervention by influencing the factors* that determine the value of a currency.* Inflation, interest rates, income level,

government controls, expectations

Government Intervention

• For example, the RBI may attempt to increase interest rates (and hence boost the rupee’s value) by reducing the Indian money supply.

• Some governments have also used foreign exchange controls (such as restrictions on currency exchange) as a form of indirect intervention.

Government Intervention

Intervention as a Policy Tool

• Like tax laws and the money supply, the exchange rate is a tool that a government can use to achieve its desired economic objectives.

• A weak home currency can stimulate foreign demand for products, and hence reduce unemployment at home. However, it can also lead to higher inflation.

Intervention as a Policy Tool

• A strong currency may cure high inflation, since it intensifies foreign competition and forces domestic producers to refrain from increasing prices. However, it may also lead to higher unemployment.

India’s Exchange Rate Experience

In 1972, when the pound was floated, the rupee kept parity with the British pound

Between 1975 and 1991 India followed the basket of currency system, 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 sizeable downward adjustment of the rupee value

LERMS – Liberalized Exchange Rate Management System – 50% of the currency was freely convertible at market exchange rate, and 50% under a managed float

1993 Unified Exchange Rate System Convertibility of the rupee under current account No full convertibility and capital account convertibility

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 of semiconductors

(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

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-risk lending by

banks The bulk of capital inflow initially went into manufacturing and

infrastructure, but later large speculative investments were made in real estate, stock purchase and consumer credit

Banks did not have adequate financial supervisory and regulatory system 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 accounting

practices were introduced Very little exposure to real estate by Indian banks Public sector ownership and trade unions reduce efficiency