Government influence

on Exchange Rate
 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
 Fixed Exchange Rate System

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.
 Monetary Policy with Fixed Exchange Rates

Expanding the Money Supply Worsens the Balance of Payments

Capital flows out.
(in the short run)

To improve a poor The overall

Interest rate
macroeconomic payments balance
drops
situation, a “worsens.”
country increases
its money supply
so that banks are
more willing to The Current account
Real spending,
lend. balance “worsens” as
production, and
exports fall and imports
income rise, but
increase.

The price level

increases.
 Freely Floating
Exchange Rate System
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.
 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
 Managed Float
Exchange Rate System

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.
 Monetary Policy with Floating Exchange Rates

Effects of Expanding the Money Supply

Capital flows out.

(In the short run)

Currency The Real

With an Interest
depreciation and Current product
increase in the rate
automatic account and
money supply, drops
adjustment begins! balance income
banks are
more willing improves rise more
to lend.
Real spending, Current account
production, and balance “worsens.”
income rise.

The Price level

increases.
(Beyond the short run)
 Pegged
Exchange Rate System
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)
 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 Boards
 Local 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
Floating Rate System:
Afghanistan Hungary Paraguay Sweden
Argentina India Peru Switzerland
Australia Indonesia Poland Taiwan
Bolivia Israel Romania Thailand
Brazil Jamaica Russia United Kingdom
Canada Japan Singapore Venezuela
Chile Mexico South Africa
Euro countries Norway South Korea

Pegged Rate System:

Bahamas Bermuda Hong Kong Pegged to
Barbados China Saudi Arabia U.S. dollar
 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
 A Single European Currency

• 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.
 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.
 Government 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.
Effects of Direct Central Bank Intervention
in the Foreign Exchange Market

RBI exchanges Rs for $ RBI exchanges $ for Rs

to strengthen the $ to weaken the $
Value Value S1
of $ S1 of $ S2
V2 V1
V1
D2 V2
D1 D1

Quantity of $ Quantity of $
 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
 Government Intervention
Non-sterilized Intervention
• 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
Non-sterilized Foreign Exchange
Intervention
Central Bank Reserve System Central Bank Reserve System
Assets Liabilities Assets Liabilities
Foreign -$1B Currency in -$1B Foreign -$1B Deposits -$1B
Assets circulation Assets with the RBI
(International (International (reserves)
Reserves) Reserves)

• 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
 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
Central Bank Reserve System
Assets Liabilities
Foreign Assets Monetary Base
(International Reserves) -$1B (reserves) 0
Government Bonds +$1B

• 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
Non-sterilized versus Sterilized Intervention
Nonsterilized Sterilized

RBI Reserve T- securities

To Rs $ Financial
Strengthen Rs institutions
the $: Banks participating that invest
in the foreign in Treasury
exchange market securities

Rs
RBI Reserve
To Weaken Rs $ Financial
T- securities
the $: institutions
Banks participating that invest
in the foreign in Treasury
exchange market securities
 Government Intervention
• 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.
 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