Jharkhand 4~Exchange Rate Policy

8/14/2019 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

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Jharkhand 4~Exchange Rate Policy

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