Chapter20:GovernmentPoliciestowardtheForeignExchangeMarketTwoAspects:RateFlexibilityandRestrictionsinUsePolicytowardthelevelandvariabilityofthe(nominalspot)exchangerate.Insimpleterms,thechoicebetweenafloatingexchangerateandafixedexchangerate.Restrictions(ifany)ontheuseoftheforeignexchangemarket.Theserestrictionsaregenerallycalledexchangecontrols.Capitalcontrolsareaformofexchangecontrolthatlimitaccessforsometypesoffinancialtransactions?2016McGraw-HillEducation.AllRightsReserved.2FloatingExchangeRateCleanfloat:Governmentpolicyletsnonofficialmarketsupplyanddemanddeterminetheexchangerate,therateisfreetogowhereverthemarketequilibriumisatthattimeOfficialintervention:Thegovernmenttriestohaveadirectimpactontheexchangeratebybuyingorsellingforeigncurrency(inexchangefordomesticcurrency)AnexchangeratethatisgenerallyfloatingbutwiththegovernmentwillingtointervenetoattempttoinfluencethemarketrateManagedfloat:ifoptimisticDirtyfloat:ifpessimistic?2016McGraw-HillEducation.AllRightsReserved.3FixedExchangeRateIfthegovernmentchoosesthepolicyofafixedexchangerate,thenthegovernmentsetstheexchangeratethatitwants.Someflexibilityispermittedwithinarange(aband),aroundthischosenfixedrate(parvalueorcentralvalue)Flexibilityismorelimitedthanwouldoccurifthegovernmentinsteadpermittedafloatingrate?2016McGraw-HillEducation.AllRightsReserved.4WhattoFixto?Afixedratemeansthatthevalueofacountry’scurrencyisfixedtosomethingelse,butwhatisthissomethingelse?Toacommodity(e.g.gold)Toasinglecurrency(e.g.dollaroreuro)ToabasketofthecurrenciesOneready-madebasketisthespecialdrawingright(SDR),acombinationoffourmajorcurrencies?2016McGraw-HillEducation.AllRightsReserved.5WhentoChangetheFixedRate?Never:Permanentlyfixedrate.Notcredible.Occasionally:Adjustablepeg.Inthefaceofsubstantialorfundamentaldisequilibriuminthecountry’sinternationalposition,thegovernmentmaychangethepegged-ratevalue.Often:Crawlingpeg.Thepegged-ratevalueischangedoften.Possiblyaccordingtoasetofindicators,e.g.inflationdifferentials,orthecountry’sholdingsofofficialinternationalreserves.?2016McGraw-HillEducation.AllRightsReserved.6DefendingaFixedExchangeRateInterveneinforeignexchangemarketbybuyingorsellingforeigncurrencyinexchangefordomesticcurrency,tomaintainorinfluencetheactualexchangerateinthemarketImposesomeformofexchangecontroltomaintainorinfluencetheexchangeratebyconstrictingdemandandsupplyinthemarketAlterdomesticinterestratestoinfluenceshort-termcapitalflows,thusinfluencingtheexchangeratebyshiftingthesupply-demandpositioninmarketAdjustthewholeeconomy’smacroeconomicpositiontomakeit“fit”thechosenfixedexchangeratevalueAnotheroption:Surrenderratherthandefendthefixedexchangerate,byalteringthefixedexchangeratethroughdevaluationorrevaluation,orswitchingtoafloatingexchangerate.?2016McGraw-HillEducation.AllRightsReserved.7DefenseThroughOfficialInterventionDefendingagainstdepreciationDefendingagainstappreciationTemporarydisequilibriumDisequilibriumthatisnottemporary?2016McGraw-HillEducation.AllRightsReserved.8InterventiontoDefendaFixedRate:PreventingDepreciationoftheCountry’sCurrency?2016McGraw-HillEducation.AllRightsReserved.9DefendingAgainstDepreciationThecountry’smonetaryauthorityintervenesbybuyingitsowncurrencyandsellingforeigncurrency(e.g.,U.S.dollars)TheauthorityusesitsownofficialinternationalreserveassetsasthesourceofthedollarsitsellsTherearefourmajorcomponentstoacountry’sofficialreserveassetsThecountry’sholdingsofforeignexchangeassetsdenominatedinthemajorcurrenciesoftheworldThecountry’sreservepositionwiththeIMFThecountry’sholdingsofSpecialDrawingRights(SDRs)Thecountry’sholdingsofgoldThroughinterventionthemonetaryauthorityisfinancingthecountry’sdeficitinitsofficialsettlementbalance?2016McGraw-HillEducation.AllRightsReserved.10OfficialHoldingsofReserveAssets,EndofYear,1970-2012(BillionsofU.S.Dollars)?2016McGraw-HillEducation.AllRightsReserved.11

DefendingAgainstDepreciation

Inbuyingdomesticcurrency,thecountry’smonetaryauthorityisremovingdomesticcurrencyfromtheeconomyThiswillreducethedomesticmoneysupplyunlesstheauthorityseparatelytakesaction(sterilization)torestorethedomesticmoneybackintotheeconomyIftheauthoritydoestakeactiontopreventthedomesticmoneysupplyfromchanging,thentheauthorityisrelyingonlyontheinterventiontodefendthefixedrate(sterilizedintervention)?2016McGraw-HillEducation.AllRightsReserved.12DefendingAgainstAppreciationThecountry’smonetaryauthorityintervenesbysellingitsowncurrencyandbuyingforeigncurrency(e.g.,U.S.dollars)TheauthorityaddsthedollarsitbuystoitsholdingsofofficialinternationalreserveassetsInsellingdomesticcurrency,thecountry’smonetaryauthorityisaddingdomesticcurrencyintotheeconomyThiswillincreasethedomesticmoneysupplyunlesstheauthorityseparatelytakesaction(sterilization)toremovethedomesticmoneyfromtheeconomyThroughinterventionthemonetaryauthorityisfinancingthecountry’ssurplusinitsofficialsettlementbalance?2016McGraw-HillEducation.AllRightsReserved.13InterventiontoDefendaFixedRate:PreventingAppreciationoftheCountry’sCurrency?2016McGraw-HillEducation.AllRightsReserved.14TemporaryDisequilibriumIfimbalancesareclearlytemporary,thendefendingthefixedexchangeratepurelythroughinterventioncanworkandmakessense.Itiscrucialthatthegovernmentofficialscorrectlypredictthefuturedemandandsupplyforforeignexchangeandtheypredictwhatwouldbeanequilibriumpathforexchangerateintheabsenceoftheirintervention.Isthegovernmentreallyneeded?Whydon’tprivatespeculatorsseeandtakeadvantageoftheopportunity??2016McGraw-HillEducation.AllRightsReserved.15ASuccessfulFinancingofTemporaryDeficitsandSurplusesataFixedExchangeRate?2016McGraw-HillEducation.AllRightsReserved.16DisequilibriumThatIsNotTemporaryIfthedomesticcurrencyisfacingpressuretowarddepreciationbecauseofanongoingoverallpaymentsdeficit,theauthoritymustcontinuallyintervenetosellforeigncurrencyIfthedomesticcurrencyisfacingpressuretowardappreciationbecauseofanongoingoverallpaymentssurplus,theauthoritymustcontinuallyintervenetobuyforeigncurrencyForacountrythatdefendsitsfixedrateusingintervention,thecountry’smonetaryauthorityiscontinuallylosingreserves(orborrowingforeignexchange)iftheimbalanceisadeficit,oritiscontinuallyaccumulatingreservesifimbalanceisasurplusFundamentaldisequilibriumcallsforadjustment,notmerelyfinancing?2016McGraw-HillEducation.AllRightsReserved.17ExchangeControlsSociallyinferiortotheotheroptionsfordefendingafixedexchangerate,andwidelyusedAnalogoustoquantitativerestrictions(quotas)onimportsAtleastasdamagingasuniformtaxonallforeigntransactions,andprobablyworse?2016McGraw-HillEducation.AllRightsReserved.18TheBestoftheWorst:WelfareLossesfromWell-ManagedExchangeControls?2016McGraw-HillEducation.AllRightsReserved.19ExchangeControls:ProbablyWorsethanAreaCEASomelower-valuedusesmaybeapprovedinplaceofhigher-valuedusesOftenincurlargeadministrativecoststoenforcethecontrols,aswellaslargeprivateresourcecostsEffortstoevadethemarepredictableBribesParallelmarket(blackmarket):awayforprivatedemandersandsellersofforeignexchangetocircumventtheexchangecontrols?2016McGraw-HillEducation.AllRightsReserved.20InternationalCurrencyExp