Economic Analysis assignment

Foreign exchange market

Submitted to : Mrs. Gargi Bandhopadhyay
Submitted by:
Students name Roll no.
Garima Sharma 108H21
Nidhi Upadhyay 108H25
Kanika Bhatia 108H26
Paras Suri 108H39
Ishaan Saxena 108H43
Gurneet Singh 108H55
Shivangi oshi 108H58
!MB" #$ass o% &'(')
1
*e#$aration
We hereby declare that ths ass!nment enttled "#ore!n $%chan!e &ar'et( s )rtten and
submtted by us under the 'nd !udance o* &rs. +ar! ,andho-adhyay.
.he content o* the -ro/ect s based on secondary data collecton. .hs ass!nment s not co-ed
*rom any source or other -ro/ect submtted *or the smlar -ur-ose.
2
"+KN,-./*G/M/N0
.hs ass!nment )ould ha0e been m-ossble )thout a host o* hel-n! hands /onn! to ma'e
the load l!hter. .he )or' no) com-leted bears testmony to ther 'nd su--ort )e a0aled
durn! ts *ormaton.
We )ould l'e to be !rate*ul to our *aculty1 &rs +ar! ,andho-adhyay1 *or her !udance and
encoura!n! su--ort. 2lso1 to the lbrary at 2mty ,usness school *or -ro0dn! us )th the
boo's )hch )ere the source o* n*ormaton o* our -ro/ect.
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+ontents
0opi# Page no.
1. #ore!n e%chan!e mar'et3 2n ntroducton 1
2. #ore!n e%chan!e nstruments. 4
3. #actors n*luencn! $%chan!e rates 5
4. 4etermnaton o* $%chan!e Rates 10
5. #ore!n $%chan!e #orecastn! n -ractce 19
6. 5**cal 2ctons to n*luence $%chan!e Rates 23
6. #le%ble 07s #%ed $%chan!e rates 26
8.,blo!ra-hy 29
0he 1oreign /x#hange Market: "n introdu#tion
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-hat is %oreign ex#hange rate or ex#hange rate2
2n e%chan!e rate s sm-ly the -rce o* one currency n terms o* another. .he -rocess by )hch
that -rce s determned de-ends on the -artcular e%chan!e rate mechansm ado-ted. 8n a
*loatn! rate system1 the e%chan!e rate s determned drectly by mar'et *orces1 and s lable to
*luctuate contnually1 as dctated by chan!n! mar'et condtons. 8n a 9*%ed91 or mana!ed rate
system1 the authortes attem-t to re!ulate the e%chan!e rate at some le0el that they consder
a--ro-rate. Such a system o*ten seems a--ealn! to those )ho are troubled by the uncertantes
o* the -resent1 h!hly 0olatle1 *loatn! rate en0ronment.
,ut the choce o* e%chan!e rate re!me n0ol0es consderatons that e%tend beyond the stablty
or other)se o* currency -rces. .hs )ll become clearer a*ter an e%amnaton o* some
*undamentals o* the *ore!n e%chan!e mar'et.
/#onomi#s o% the 1oreign /x#hange Market
8n a *loatn! e%chan!e rate re!me the -rce o* the dollar1 l'e any other mar'et:determned -rce1
de-ends on the rele0ant *orces o* su--ly and demand. ,ut )hat are the rele0ant *orces o* su--ly
and demand n the *ore!n e%chan!e mar'et;
.o try to ans)er ths <ueston1 let us consder1 *or llustraton1 the *actors that determne the
relatonsh- bet)een the 2ustralan dollar and the =a-anese yen. .he =a-anese re<ure dollars to
-ay *or ther m-orts o* !oods and ser0ces *rom 2ustrala and to *und any n0estment they may
)sh to underta'e n ths country. 2ssume that they obtan these dollars on the *ore!n e%chan!e
mar'et by su--lyn! >selln!? yen n return. So the =a-anese demand *or dollars >mrrored by the
su--ly o* yen? s determned by the e%-orts to =a-an and our ca-tal n*lo) *rom that country.
5n the other sde o* the mar'et1 the 2ustralan demand *or yen s determned by our need to -ay
*or m-orts *rom =a-an1 and *or any ca-tal n0estment that )e underta'e there. We buy those yen
by su--lyn! 2ustralan dollars n return. .hus the su--ly o* dollars >mrrored by the demand *or
yen? s determned by our m-orts *rom =a-an and our ca-tal out*lo) to that country.
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8n summary1 then1 the demand *or 2ustralan dollars re*lects the beha0or o* our e%-orts and
ca-tal n*lo)1 )hle the su--ly o* dollars re*lects the beha0or o* our m-orts and ca-tal
out*lo). 8n other )ords1 transactons on the *ore!n e%chan!e mar'et echo the nternatonal trade
and *nancal transactons that are summar@ed n the balance o* -ayments. Wthn the balance o*
-ayments1 the relatonsh- bet)een our e%-orts and m-orts o* !oods and ser0ces s ca-tured by
the balance o* current account1 )hle the relatonsh- bet)een ca-tal n*lo) and ca-tal out*lo)
s ca-tured by the balance o* ca-tal account. .he act0tes o* nternatonal currency s-eculators
a**ect the e%chan!e rate drectly throu!h ther m-act on ca-tal *lo)s.
.he dstn!ushn! characterstc o* a *loatn! e%chan!e rate system s that the -rce o* a currency
ad/usts automatcally to )hate0er le0el s re<ured to e<uate the su--ly o* and demand *or that
currency1 thereby clearn! the mar'et. .he lo!c o* the relatonsh- bet)een our nternatonal
transactons and the su--ly and demand *or currences m-les that ths mar'et:clearn!1 or
9e<ulbrum91 -rce also -roduces automatc e<ulbrum n the balance o* -ayments. .hat s1 the
balance o* current account >)hether -ost0e1 ne!at0e1 or @ero? must be -recsely o**set by the
balance >ne!at0e1 -ost0e1 or @ero? o* the ca-tal account. Ander *loatn! e%chan!e rates these
outcomes are ache0ed automatcally )thout the need *or !o0ernment nter0enton. ,y contrast1
under *%ed e%chan!e rates balance o* -ayments e<ulbrum s not the normal condton.
.hese characterstcs o* the *loatn! e%chan!e rate mechansm ha0e m-ortant m-lcatons both
*or the nature o* our relatonsh- )th the !lobal en0ronment1 and *or the -olcy o-tons
a0alable to the authortes n mana!n! the economy. Bet us no) consder some o* these.

Internationa$ 0ransmission o% /#onomi# Stabi$ity

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2 *le%ble e%chan!e rate acts as a 'nd o* shoc' absorber that hel-s to nsulate us a!anst
o0erseas dsturbances. .hs s because the relatonsh- bet)een our nternatonal transactons and
the *ore!n e%chan!e mar'et runs n both drectons. Bet us su--ose1 *or e%am-le1 that recesson
n the =a-anese economy leads to a declne n the demand *or 2ustralan e%-orts. 8n tsel*1 ths
)ll tend to reduce economc act0ty n 2ustrala. ,ut ths tendency )ll be o**set by an
assocated de-recaton o* the dollar1 )hch )ll nduce an e%-anson o* e%-orts1 a contracton o*
m-orts1 and -erha-s an ncrease n net ca-tal n*lo)1 all o* )hch )ll hel- to cushon the
2ustralan economy a!anst recesson. 2n analo!ous mechansm )ould o-erate to reduce the
m-act o* an ntal declne n =a-anese n0estment n 2ustrala. ,oth cases llustrate the role o*
e%chan!e rate *le%blty n nsulatn! our economy to some de!ree a!anst nternatonal
economc nstablty. ,y the same reasonn!1 *loatn! e%chan!e rates also hel- to dmnsh the
nternatonal transmsson o* our o)n domestc economc nstablty.
+hara#teristi#s o% the 1oreign /x#hange Market
.he #ore% mar'et does not e%st -hyscally1 t s a *rame)or' )here -artc-ants are connected
by com-uters1 tele-hones and tele% >SW8#.? and o-erates n most *nancal centres !lobally.
,ecause the #ore% mar'et s so h!hly nte!rated !lobally1 t can o-erate 24 hours a day C )hen
one ma/or mar'et s closed1 another ma/or mar'et s o-en to *acltate trade occurrn! 24 hours a
day mo0n! *rom one ma/or mar'et to another. &ost e%chan!es o* currency are made throu!h
ban' de-osts .e. trans*erred electroncally *rom one account to another.
.he 0olume o* *ore!n e%chan!e transactons )orld)de s assumed to be a--ro%mately AS4 2
trllon -er day. .he a0era!e daly turno0er n the South 2*rcan mar'et s R11 bllon -er day
and Standard ,an' s the reco!nsed leader n the domestc *ore!n e%chan!e mar'et1 handln!
more than 30D o* South 2*rca9s *ore!n e%chan!e 0olume. .he #ore% mar'et s an o0er:the:
counter mar'et .e. tradn! n *nancal nstruments that are not lsted or a0alable on an o**cally
reco!nsed e%chan!e >such as the =S$ C =ohannesbur! Stoc' $%chan!e?1 but traded n drect
ne!otaton bet)een buyers and sellers. .radn! ta'es -lace tele-honcally or electroncally.
-hy do 3e make use o% the 1oreign /x#hange Market2
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.radn! n a domestc mar'et s substantally d**erent *rom don! busness n an o**shore
mar'et. 8n the com-le% )orld o* nternatonal trade1 merchants *ace a number o* rs's that need
to be mana!ed n order to ensure the success o* ther cross C border transactons. 8n order to
-rotect themsel0es1 these cor-oratons a--ly hed!n! techn<ues usn! 0arous *ore!n e%chan!e
nstruments and -roducts n order to ne!ate the m-acts o* e%chan!e rate *luctuatons. Success*ul
com-anes em-loy e**ect0e rs' mana!ement techn<ues )hen ma'n! busness decsons1 and
e0aluate commercal rs' n an e%-lct and lo!cal manner n order to o**set *nancal loss
occasoned by the 0olatlty n e%chan!e rates >currency rs'?.
-ho are the 1oreign /x#hange Market Parti#ipants2
Eommercal ,an's -artc-ate n the mar'et by o**ern! to buy and sell *ore!n e%chan!e on
behal* o* ther retal or )holesale customers as a -art o* ther *nancal ser0ce. .hey also trade n
*ore!n e%chan!e as an ntermedary and mar'et ma'er. >2 mar'et ma'er <uotes a buy and sell
-rce on a currency or *nancal nstrument ho-n! to ma'e a -ro*t on the s-read .e. the
d**erence bet)een the buyn! and the selln! -rce?. 5ther *nancal 8nsttutons1 such as ,ro'ers
>8nsttutonal 8n0estors1 8nsurance com-anes1 Fenson1 &utual and Hed!e #und &ana!ers? need
to mana!e 0arous -ort*olos on behal* o* ther clents1 and thus -artc-ate n the *ore!n
e%chan!e mar'et. .hey rely on the rates <uoted by the mar'et ma'ers to mar'et -artc-ants and
char!e commsson or a bro'era!e *ee *or ser0ces rendered. Eor-oratons buy and sell *ore!n
e%chan!e !enerally to *acltate trade1 or as a result o* a trade done and also to hed!e currency
e%-osures that e%st due to a -artcular trade conducted. .hese cor-oratons !enerally consst o*
e%-orters and m-orters. Eentral ,an's can sometmes nter0ene n the *ore!n e%chan!e mar'et
n order to m-lement monetary -olces.
1oreign /x#hange Instruments
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2 number o* *ore!n e%chan!e nstruments ha0e been des!ned *or e**ect0e hed!n! as )ell as
enhancement o* returns. .he *ollo)n! nstruments and -roducts are most common to the
#ore!n $%chan!e &ar'et to *acltate nternatonal trade and )ll be co0ered n *uture #ore%
,ulletns3 S-ot transactons1 #or)ard .ransactons >#$Es?1 5-tons >4er0at0es o* e%chan!e
rates?1 8nternatonal money trans*ers1 +uarantees1 Eommercal Eustomer #ore!n Eurrency
accounts1 4ocumentary Eredt and Eollectons1
1a#tors in%$uen#ing ex#hange rates
#ore!n e%chan!e rates are e%tremely 0olatle and t s ncumbent on those n0ol0ed )th *ore!n
e%chan!e : ether as a -urchaser1 seller1 s-eculator or nsttuton : to 'no) )hat causes rates to
mo0e.
2ctually1 there are a 0arety o* *actors : mar'et sentment1 the state o* the economy1 !o0ernment
-olcy1 demand and su--ly and a host o* others.
.he more m-ortant *actors that n*luence e%chan!e rates are dscussed belo)3
Strength of the Economy :.he stren!th o* the economy a**ects the demand and su--ly o*
*ore!n currency. 8* an economy s !ro)n! *ast and s stron! t )ll attract *ore!n currency
thereby stren!thenn! ts o)n. 5n the other hand1 )ea'nesses result n an out*lo) o* *ore!n
e%chan!e. 8* a country s a net e%-orter >as )ere =a-an and +ermany?1 the n*lo) o* *ore!n
currency *ar outstr-s the out*lo) o* ther o)n currency. .he result s usually a stren!thenn! n
ts 0alue.
Political and Psychological Factors: Foltcal or -sycholo!cal *actors are bele0ed to ha0e an
n*luence on e%chan!e rates. &any currences ha0e a tradton o* beha0n! n a -artcular )ay
such as S)ss *rancs )hch are 'no)n as a re*u!e or sa*e ha0en currency )hle the dollar mo0es
>ether u- or do)n? )hene0er there s a -oltcal crss any)here n the )orld. $%chan!e rates
can also *luctuate * there s a chan!e n !o0ernment. Some tme bac'1 8ndas *ore!n e%chan!e
ratn! )as do)n!raded because o* -oltcal nstablty and conse<uently1 the e%ternal 0alue o* the
ru-ee *ell. Wars and other e%ternal *actors also a**ect the e%chan!e rate. #or e%am-le1 )hen ,ll
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Elnton )as m-eached1 the AS dollar )ea'ened. 4urn! the 8ndo:Fa' )ar the ru-ee )ea'ened.
2*ter the 1999 cou- n Fa'stan >5ctober7Go0ember 1999?1 the Fa'stan ru-ee )ea'ened.
Economic Expectations 3$%chan!e rates mo0e on economc e%-ectatons. 2*ter the 1999 bud!et
n 8nda there )as an e%-ectaton that the ru-ee )ould *all by 6D to 9D. Snce such e%-ectatons
a**ect the e%ternal 0alue o* the ru-ee1 all economc data : the balance o* -ayments1 e%-ort
!ro)th1 n*laton rates and the l'es : are analysed and ts l'ely e**ect on e%chan!e rates s
e%amned. 8* the economc do)nturn s not as bad as antc-ated the rate can e0en a--recate.
.he mo0ement really de-ends on the "mar'et sentment( : the mood o* the mar'et : and ho)
much the mar'et has reacted or dscounted the antc-ated7e%-ected n*ormaton.
Inflation Rates : 8t s )dely held that e%chan!e rates mo0e n the drecton re<ured to
com-ensate *or relat0e n*laton rates. #or nstance1 * a currency s already o0er0alued1 .e.
stron!er than )hat s )arranted by relat0e n*laton rates1 de-recaton su**cent enou!h to
correct that -oston can be e%-ected and 0ce 0ersa. 8t s necessary to note that an e%chan!e rate
s a relat0e -rce and hence the mar'et )e!hs all the relat0e *actors n relat0e terms >n
relaton to the counter-art countres?. .he underlyn! reasonn! behnd ths con0cton s that a
relat0ely h!h rate o* n*laton reduces a countrys com-ett0eness and )ea'ens ts ablty to sell
n nternatonal mar'ets. .hs stuaton1 n turn1 )ll )ea'en the domestc currency by reducn!
the demand or e%-ected demand *or t and ncreasn! the demand or e%-ected demand *or the
*ore!n currency >ncrease n the su--ly o* domestc currency and decrease n the su--ly o*
*ore!n currency?.
Capital Movements : Ea-tal mo0ements are one o* the most m-ortant reasons *or chan!es n
e%chan!e rates. Ea-tal mo0ements o* *ore!n currency are usually more than connected )th
nternatonal trade. .hs occurs due to a 0arety o* reasons : both -ost0e and ne!at0e. When
8nda be!an ts economc lberalsaton and n0ted #ore!n 8nsttutonal 8n0estors >#88s? to
-urchase e<uty shares n 8ndan com-anes1 bllons o* AS dollars came nto the country
stren!thenn! the currency. 8n 1996 and 19961 #88s too' se0eral bllon AS dollars out o* the
country )ea'enn! the currency. .hese )ere ca-tal out*lo)s. 5ne o* the reasons -o-ularly
bele0ed *or the ru-ee not de-recatn! n the manner other South:east 2san currences dd n
1996:98 )as because the ru-ee )as not con0ertble on the "ca-tal account(.
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Speculation 3 S-eculaton n a currency rases or lo)ers the e%chan!e rate. #or nstance1 the
*ore!n e%chan!e mar'et n Henya s 0ery shallo). 8* a s-eculator enters and buys AS I1 mllon1
t )ll rase the 0alue o* the AS dollar s!n*cantly. 8* a *e) others do so too1 the -rce o* the AS
dollar )ll rse e0en *urther a!anst the Henya shlln!. .he most *amous s-eculator n *ore!n
currency s &r +eor!e Soros )ho made o0er a bllon -ounds sterln! n $uro-e >by correctly
-redctn! the de0aluaton o* the -ound? and then s bele0ed to ha0e tr!!ered the *ree *all o* the
currences o* South:east 2sa.
. Balance of Payments 3 2s mentoned earler1 a net n*lo) o* *ore!n currency tends to
stren!then the home currency 0s:J:0s other currences. .hs s because the su--ly o* the *ore!n
currency )ll be n e%cess o* demand. 2 !ood )ay o* ascertann! ths )ould be to chec' the
balance o* -ayments. 8* the balance o* -ayments s -ost0e and *ore!n e%chan!e reser0es are
ncreasn!1 the home currency )ll become stron!er.
overnment!s Monetary and Fiscal Policies : +o0ernments1 throu!h ther monetary and *scal
-olces a**ect nternatonal trade1 the trade balance and the su--ly and demand *or a currency.
8ncreasn! the su--ly o* money rases -rces and ma'es m-orts attract0e. #scal sur-luses )ll
slo) economc !ro)th and ths )ll reduce demand *or m-orts and encoura!e e%-orts. .he
e**ect0eness o* the -olcy de-ends on the -rce and ncome elastctes o* demand *or the
-artcular !oods. H!h -rce elastcty o* demand means the 0olume o* a !ood s senst0e to a
chan!e n -rce. &onetary and *scal -olcy su--ort the currency throu!h a reducton n n*laton.
.hese also a**ect e%chan!e rate throu!h the ca-tal account. Get ca-tal n*lo)s su--ly drect
su--ort *or the e%chan!e rate. Eentral !o0ernments control monetary su--ly and they are
e%-ected to ensure that the !o0ernments monetary -olcy s *ollo)ed. .o ths e%tent they could
ncrease or decrease money su--ly. #or e%am-le1 the Reser0e ,an' o* 8nda1 to curb n*laton1
restrcted and cut money su--ly. 8n Henya1 the central ban' n order to attract *ore!n money nto
the country s o**ern! 0ery h!h rates on ts treasury blls. 8n order to mantan e%chan!e rates at
a certan -rce the central ban' )ll also nter0ene ether by buyn! *ore!n currency >)hen there
s an e%cess n the su--ly o* *ore!n e%chan!e? and selln! *ore!n currency >)hen demand *or
*ore!n e%chan!e e%ceeds su--ly?. .hs s 'no)n as Kcentral ban' nter0enton. 8t must be noted
that the ob/ect0e o* monetary -olcy s to mantan stablty and economc !ro)th and central
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ban's are e%-ected to : by ncreasn!7decreasn! money su--ly1 rasn!7lo)ern! nterest rates or
by o-en mar'et o-eratons : mantan stablty.
Exchange Rate Policy and Intervention3 $%chan!e rates are also n*luenced1 n no small
measure1 by e%-ectaton o* chan!e n re!ulatons relatn! to e%chan!e mar'ets and o**cal
nter0enton. 5**cal nter0enton can smoothen an other)se dsorderly mar'et. 2s e%-laned
be*ore1 nter0enton s the buyn! or selln! o* *ore!n currency to ncrease or decrease ts su--ly.
Eentral ban's o*ten nter0ene to mantan stablty. 8t has also been e%-erenced that * the
authortes attem-t to hal*:heartedly counter the mar'et sentments throu!h nter0enton n the
mar'et1 ultmately more stee- and sudden e%chan!e rate s)n!s can occur.
Interest Rates : 2n m-ortant *actor *or mo0ement n e%chan!e rates n recent years s nterest
rates1 .e. nterest d**erental bet)een ma/or currences. 8n ths res-ect the !ro)n! nte!raton o*
*nancal mar'ets o* ma/or countres1 the re0oluton n telecommuncaton *acltes1 the !ro)th
o* s-ecalsed asset mana!n! a!ences1 the dere!ulaton o* *nancal mar'ets by ma/or countres1
the emer!ence o* *ore!n tradn! as -ro*t centres -er se and the tremendous sco-e *or
band)a!on and s<uarn! e**ects on the rates1 etc. ha0e accelerated the -otental *or e%chan!e rate
0olatlty.
Henya ntrnscally has a 0ery )ea' economy but the rates o**ered )thn the country ha0e
al)ays been 0ery h!h. .o llustrate ths -ont the treasury bll rate n Se-tember 1998 )as as
h!h as 23D. H!h nterest rates attract s-eculat0e ca-tal mo0es so the announcements made by
the #ederal Reser0e on nterest rates are usually ea!erly a)ated : an ncrease n the same )ll
cause an n*lo) o* *ore!n currency and the stren!thenn! o* the AS dollar.
"ariffs and #uotas 3 .ar**s and <uotas e%st to -rotect a countrys *ore!n e%chan!e by reducn!
demand. .ll be*ore lberalsaton1 8nda *ollo)ed a -olcy o* tar**s and restrctons on m-orts.
Lery *e) tems )ere -ermtted to be *reely m-orted. 2ddtonally1 h!h customs dutes )ere
m-osed to dscoura!e m-orts and to -rotect the domestc ndustry. .ar**s and <uotas are not
-o-ular nternatonally as they tend to close mar'ets. When 8nda l*ted ts barrers1 se0eral
ndustres such as the mn steel and the scra- metal ndustres colla-sed >m-orted scra- became
chea-er than the domestc one?. Muotas are not restrcted to de0elo-n! countres. .he Anted
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States m-oses <uotas on readymade !arments and =a-an has se0ere <uotas on non:=a-anese
!oods.
Exchange Control 3 .he -ur-ose o* e%chan!e control s to mana!e the su--ly and demand
balance o* the home currency by the !o0ernment usn! drect controls bascally to -rotect t.
Eurrency control s the restrcton o* usn! or a0aln! o* *ore!n currency at home7abroad.
8n 8nda1 u- to lberal@aton n the nnetes there )as 0ery se0ere e%chan!e control. 2ccess to
*ore!n currency )as t!htly controlled and the same )as released only *or -ermtted -ur-oses.
.hs )as because 8ndan e%-orts had not ta'en o** and there )ere stll lar!e m-orts. .here are
se0eral countres that mantan ther rates at art*cal le0els such as ,an!ladesh.
8nda s no) *ully1 con0ertble on the current account but not as yet on the ca-tal account. .hs1
to an e%tent1 -ossbly sa0ed 8nda )hen the run on currences too' -lace n 2sa n 1996. 8* the
8ndan ru-ee )as *ully con0ertble and there )ere no e%chan!e control restrctons1 the ru-ee
)ould ha0e been o-en *or s-eculaton. .here )ould ha0e been lar!e out*lo)s at a tme o*
concern resultn! n a sno)balln! -lun!e n ts 0alue.
2s lon! as the -ar 0alue system -re0aled1 the rates could not !o beyond the u--er and lo)er
nter0enton -onts. .he only real <ueston under the *%ed rate system )as )hether the balance
o* -ayments and *ore!n e%chan!e reser0es had deterorated to such an e%tent that de0aluaton
)as mmnent or -ossble. Eountres )th stron! balance o* -ayments and reser0e -ostons )ere
hardly called u-on to re0alue ther currences. Hence1 a )atch had to be 'e-t only on de*ct
countres. Ho)e0er1 under !eneral@ed *loatn! re!me1 e%chan!e rates are n*luenced by a
multtude o* economc1 *nancal1 -oltcal and -sycholo!cal *actors. ,ut the relat0e
s!n*cance o* any o* these *actors can 0ary *rom tme to tme ma'n! t d**cult to -redct
-recsely ho) any sn!le *actor )ll n*luence the rates and by ho) much.
13
*etermination o% /x#hange 4ates
8n sm-le terms1 t s the nteracton o* su--ly and demand *actors *or t)o currences n the
mar'et that determnes the rate at )hch they trade. ,ut )hat *actors n*luence the many
thousands o* decsons made each day to buy or sell a currency; Ho) do chan!es n su--ly and
demand condtons e%-lan the -ath o* an e%chan!e rate o0er the course o* a day1 a month1 or a
year;
.hs com-le% ssue has been e%tens0ely studed n economc lterature and )dely dscussed
amon! n0estors1 o**cals1 academcans1 traders1 and others. Stll1 there are no de*nt0e
ans)ers. Le)s on e%chan!e rate determnaton d**er and ha0e chan!ed o0er tme. Go sn!le
a--roach -ro0des a sats*actory e%-lanaton o* e%chan!e rate mo0ements1 -artcularly short: and
medum:term mo0ements1 snce the ad0ent o* )des-read *loatn! n the early 1960s.
.hree as-ects o* e%chan!e rate determnaton are dscussed belo). #rst1 there s a bre*
descr-ton o* some o* the broad a--roaches to e%chan!e rate determnaton. Second1 there are
some comments on the -roblems o* e%chan!e rate *orecastn! n -ractce. .hrd1 central ban'
nter0enton and ts e**ects on e%chan!e rates are dscussed.
Some a--roaches to e%chan!e rate determnaton3
"he Purchasing Po$er Parity %pproach
Furchasn! Fo)er Farty >FFF? theory holds that n the lon! run1 e%chan!e rates )ll ad/ust to
e<ual@e the relat0e -urchasn! -o)er o* currences. .hs conce-t *ollo)s *rom the la) o* one
-rce1 )hch holds that n com-ett0e mar'ets1 dentcal !oods )ll sell *or dentcal -rces )hen
0alued n the same currency.
.he la) o* one -rce relates to an nd0dual -roduct. 2 !eneral@aton o* that la) s the absolute
0erson o* FFF1 the -ro-oston that e%chan!e rates )ll e<uate natons o0erall -rce le0els. &ore
commonly used than absolute FFF s the conce-t o* relat0e FFF1 )hch *ocuses on chan!es n
14
-rces and e%chan!e rates1 rather than on absolute -rce le0els. Relat0e FFF holds that there )ll
be a chan!e n e%chan!e rates -ro-ortonal to the chan!e n the rato o* the t)o natons -rce
le0els1 assumn! no chan!es n structural relatonsh-s. .hus1 * the A.S. -rce le0el rose 10
-ercent and the =a-anese -rce le0el rose 5 -ercent1 the A.S. dollar )ould de-recate 5 -ercent1
o**settn! the h!her A.S. n*laton and lea0n! the relat0e -urchasn! -o)er o* the t)o
currences unchan!ed.
FFF s based n -art on some unrealstc assum-tons3 that !oods are dentcalN that all !oods are
tradableN that there are no trans-ortaton costs1 n*ormaton !a-s1 ta%es1 tar**s1 or restrctons o*
tradeN and Om-lctly and m-ortantlyOthat e%chan!e rates are n*luenced only by relat0e
n*laton rates.
,ut contrary to the m-lct FFF assum-ton1 e%chan!e rates also can chan!e *or reasons other
than d**erences n n*laton rates. Real e%chan!e rates can and do chan!e s!n*cantly o0er tme1
because o* such thn!s as ma/or sh*ts n -roduct0ty !ro)th1 ad0ances n technolo!y1 sh*ts n
*actor su--les1 chan!es n mar'et structure1 commodty shoc's1 shorta!es1 and booms.
8n addton1 the relat0e 0erson o* FFF su**ers *rom measurement -roblems3What s a !ood
startn! -ont1 or base -erod; Whch s the a--ro-rate -rce nde%; Ho) should )e account *or
ne) -roducts1 or chan!es n tastes and technolo!y;
FFF s ntut0ely -lausble and a matter o* common sense1 and t undoubtedly has some 0aldty
Os!n*cantly d**erent rates o* n*laton should certanly a**ect e%chan!e rates. FFF s use*ul n
assessn! lon!:term e%chan!e rate trends and can -ro0de 0aluable n*ormaton about lon!:run
e<ulbrum. ,ut t has not met )th much success n -redctn! e%chan!e rate mo0ements o0er
short: and medum:term hor@ons *or )dely traded currences. 8n the short term1 FFF seems to
a--ly best to stuatons )here a country s e%-erencn! 0ery h!h1 or e0en hy-ern*laton1 n
)hch lar!e and contnuous -rce rses o0er)helm other *actors.
"he Balance of Payments and the Internal& External Balance %pproach
15
FFF concentrates on one -art o* the balance o* -aymentsOtradable !oods and ser0cesO and
-ostulates that e%chan!e rate chan!es are determned by nternatonal d**erences n -rces1 or
chan!es n -rces1 o* tradable tems.
5ther a--roaches ha0e *ocused on the balance o* -ayments on current account1 or on the balance
o* -ayments on current account -lus lon!:term ca-tal1 as a !ude n the determnaton o* the
a--ro-rate e%chan!e rate.
,ut n todays )orld1 t s !enerally a!reed that t s essental to loo' at the entre balance o*
-aymentsOboth current and ca-tal account transactonsOn assessn! *ore!n e%chan!e *lo)s
and ther role n the determnaton o* e%chan!e rates.
=ohn Wllamson and others ha0e de0elo-ed the conce-t o* the "*undamental e<ulbrum
e%chan!e rate1( or #$$R1 en0sa!ed as the e<ulbrum e%chan!e rate that )ould reconcle a
natons nternal and e%ternal balance. 8n that system1 each country )ould commt tsel* to a
macroeconomc strate!y des!ned to lead1 n the medum term1 to "nternal balance(Ode*ned as
unem-loyment at the natural rate and mnmal n*latonOand to "e%ternal balance(Ode*ned as
ache0n! the tar!eted current account balance. $ach country )ould be commtted to holdn! ts
e%chan!e rate )thn a band or tar!et @one around the #$$R1 or the le0el needed to reconcle
nternal and e%ternal balance durn! the nter0enn! ad/ustment -erod.
.he conce-t o* #$$R1 as an e<ulbrum e%chan!e rate to reconcle nternal and e%ternal balance1
s a use*ul one. ,ut there are -ractcal -roblems n calculatn! #$$Rs..here s no un<ue ans)er
to )hat consttutes the #$$RN de-endn! on the -artcular assum-tons1 models1 and econometrc
methods used1 d**erent analysts could come to <ute d**erent results. .he authors reco!n@e ths
d**culty1 and ac'no)led!e that some allo)ance should be made by )ay o* a tar!et band around
the #$$R.Wllamson has su!!ested that #$$R calculatons could not realstcally /ust*y
e%chan!e rate bands narro)er than -lus or mnus 10 -ercent.
16
.he 8&#1 )hle !enerally a!reen! that t s not -ossble to dent*y -recse "e<ulbrum(0alues
*or e%chan!e rates and that -ont estmates o* notonal e<ulbrum rates should !enerally be
a0oded1 does use a macroeconomc balance methodolo!y to under-n ts nternal 8&#
multlateral sur0ellance. .hs mehodolo!y1 )hch s used *or assessn! the "a--ro-rateness(o*
current account -ostons and e%chan!e rates *or ma/or ndustral countres1 s descrbed n ,o%
11:1.6
"he Monetary %pproach
.he monetary a--roach to e%chan!e rate determnaton s based on the -ro-oston that e%chan!e
rates are establshed throu!h the -rocess o* balancn! the total su--ly o*1 and the total demand
*or1 the natonal money n each naton. .he -remse s that the su--ly o* money can be controlled
by the natons monetary authortes1 and that the demand *or money has a stable and -redctable
ln'a!e to a *e) 'ey 0arables1 ncludn! an n0erse relatonsh- to the nterest rateOthat s1 the
h!her the nterest rate1 the smaller the demand *or money. 8n ts sm-lest *orm1 the monetary
a--roach assumes that3 -rces and )a!es are com-letely *le%ble n both the short and lon! run1
so that FFF holds contnuously1 that ca-tal s *ully moble across natonal borders1 and that
domestc and *ore!n assets are -er*ect substtutes. Startn! *rom e<ulbrum n the money and
16
*ore!n e%chan!e mar'ets1 * the A.S. money su--ly ncreased1 say1 20 -ercent1 )hle the
=a-anese money su--ly remaned stable1 the A.S. -rce le0el1 n tme1 )ould rse 20 -ercent and
the dollar )ould de-recate 20 -ercent n terms o* the yen.
8n ths sm-l*ed 0erson1 the monetary a--roach combnes the FFF theory )th the <uantty
theory o* moneyOncreases or decreases n the money su--ly lead to -ro-ortonate ncreases or
decreases n the -rce le0el o0er tme1 )thout any -ermanent e**ects on out-ut or nterest rates.
&ore so-hstcated 0ersons rela% some o* the restrct0e assum-tonsO*or e%am-le1 -rce
*le%blty and FFF may be assumed not to hold n the short runObut mantan the *ocus on the
role o* natonal monetary -olces.
$m-rcal tests o* the monetary a--roachO sm-le or so-hstcatedOha0e *aled to -ro0de an
ade<uate e%-lanaton o* e%chan!e rate mo0ements durn! the *loatn! rate -erod. .he a--roach
o**ers only a -artal 0e) o* the *orces n*luencn! e%chan!e ratesOt assumes a)ay the role o*
nonmonetary assets such as bonds1 and t ta'es no e%-lct account o* su--ly and demand
condtons n !oods and ser0ces mar'ets. 4es-te ts lmtatons1 the monetary a--roach o**ers
0ery use*ul ns!hts. 8t h!hl!hts the m-ortance o* monetary -olcy n n*luencn! e%chan!e
rates1 and correctly )arns that e%cess0e monetary e%-anson leads to currency de-recaton.
.he monetary a--roach also -ro0des a bass *or e%-lann! e%chan!e rate o0ershootn!Oa
stuaton o*ten obser0ed n e%chan!e mar'ets n )hch a -olcy mo0e can lead to an ntal
e%chan!e rate mo0e that e%ceeds the e0entual chan!e m-led by the ne) lon!:term stuaton. 8n
the conte%t o* monetary a--roach models that ncor-orate short:term stc'ness n -rces1
e%chan!e rate o0ershootn! can occur because -rces o* *nancal assetsOnterest and e%chan!e
ratesOres-ond more <uc'ly to -olcy mo0es than does the -rce le0el o* !oods and ser0ces.
.hus1 *or e%am-le1 a money su--ly ncrease >or decrease? n the Anted States can lead to a
!reater tem-orary dollar de-recaton >a--recaton? as domestc nterest rates declne >rse?
tem-orarly be*ore the ad/ustment o* the -rce le0el to the ne) lon!:run e<ulbrum s com-leted
and nterest rates return to ther or!nal le0els.
18
"he Portfolio Balance %pproach
.he -ort*olo balance a--roach ta'es a shorter:term 0e) o* e%chan!e rates and broadens the
*ocus *rom the demand and su--ly condtons *or money to ta'e account o* the demand and
su--ly condtons *or other *nancal assets as )ell. Anl'e the monetary a--roach1 the -ort*olo
balance a--roach assumes that domestc and *ore!n bonds are not -er*ect substtutes. 2ccordn!
to the -ort*olo balance theory n ts sm-lest *orm1 *rms and nd0duals balance ther -ort*olos
amon! domestc money1 domestc bonds1 and *ore!n currency bonds1 and they mod*y ther
-ort*olos as condtons chan!e. 8t s the -rocess o* e<ulbratn! the total demand *or1 and su--ly
o*1 *nancal assets n each country that determnes the e%chan!e rate.
$ach nd0dual and *rm chooses a -ort*olo to sut ts needs1 based on a 0arety o*
consderatonsOthe holders )ealth and tastes1 the le0el o* domestc and *ore!n nterest rates1
e%-ectatons o* *uture n*laton1 nterest rates1 and so on. 2ny s!n*cant chan!e n the
underlyn! *actors )ll cause the holder to ad/ust hs -ort*olo and see' a ne) e<ulbrum.
.hese actons to balance -ort*olos )ll n*luence e%chan!e rates. 2ccordn!ly1 a naton )th a
sudden ncrease n money su--ly )ould mmedately -urchase both domestc and *ore!n bonds1
resultn! n a declne n both countres nterest rates1 and1 to the e%tent o* the sh*t to *ore!n
bonds1 a de-recaton n the natons home currency. 50er tme1 the de-recaton n the home
currency )ould lead to !ro)th n the natons e%-orts and a declne n ts m-orts1 and thus1 to an
m-ro0ed trade balance and re0ersal o* -art o* the or!nal de-recaton.
2s yet1 there s no un*ed theory o* e%chan!e rate determnaton based on the -ort*olo balance
a--roach that has -ro0ed relable n *orecastn!. 8n *act1 results o* em-rcal tests o* the -ort*olo
balance a--roach do not com-are *a0orably )th those *rom sm-ler models. .hese results
re*lect both conce-tual -roblems and the lac' o* ade<uate data on the s@e and currency
19
com-oston o* -r0ate sector -ort*olos.
20
21
Ge0ertheless1 the -ort*olo balance a--roach o**ers a use*ul *rame)or' *or studyn! e%chan!e
rate determnaton. Wth ts *ocus on a broad menu o* assets1 ths a--roach -ro0des rcher
ns!hts than the monetary a--roach nto the *orces n*luencn! e%chan!e rates. 8t also enables
*ore!n e%chan!e rates to be seen l'e asset -rces n other mar'ets1 such as the stoc' mar'et or
bond mar'et1 )here rates are n*luenced1 not only by current condtons1 but to a !reat e%tent by
mar'et e%-ectatons o* *uture e0ents. 2s )th other *nancal assets1 e%chan!e rates chan!e
contnuously as the mar'et rece0es ne) n*ormaton about current condtons and n*ormaton
that a**ects e%-ectatons o* the *uture. .he random character o* these asset -rce mo0ements
does not rule out ratonal -rcn!. 8ndeed1 t s -ersuas0ely ar!ued that ths s the result to be
e%-ected n a )ell *unctonn! *nancal mar'et. ,ut n such an en0ronment1 e%chan!e rate
chan!es can be lar!e and 0ery d**cult to -redct1 as mar'et -artc-ants try to /ud!e the e%-ected
real rates o* return on ther domestc assets n com-arson )th alternat0es n other currences.
5o3 Good "re the 6arious "pproa#hes2
.he a--roaches noted abo0e are some o* the most !eneral and most *amlar ones1 but there are
many others1 *ocusn! on d**erentals n real nterest rates1 on *scal -olces1 and on other
elements.
22
.he research on ths to-c has been o* !reat 0alue n enhancn! our understandn! o* lon!:run
e%chan!e rate trends and the ssues n0ol0ed n estmatn! "e<ulbrum( rates. 8t has hel-ed us
understand 0arous as-ects o* e%chan!e rate beha0or and -artcular e%chan!e rate e-sodes.
Pet none o* the a0alable em-rcal models has -ro0ed ade<uate *or ma'n! relable -redctons
o* the course o* e%chan!e rates o0er a -erod o* tme. Research thus *ar has not been able to *nd
stable and s!n*cant relatonsh-s bet)een e%chan!e rates and any economc *undamentals
ca-able o* consstently -redctn! or e%-lann! short:term rate mo0ements.
23
1oreign ex#hange %ore#asting in pra#ti#e
&ost o* the a--roaches to e%chan!e rate determnaton tell only -art o* the storyOl'e the
se0eral blnd*olded men touchn! d**erent -arts o* the ele-hants bodyOand other1 more
com-rehens0e e%-lanatons cannot1 n -ractce1 be used *or -recse *orecastn!. We do not yet
ha0e a )ay o* brn!n! to!ether all o* the *actors that hel- determne the e%chan!e rate n a
sn!le com-rehens0e a--roach that )ll -ro0de relable short: to medum:term -redctons.
.he e%chan!e rate s a -er0as0e and com-le% mechansm1 n*luencn! and ben! n*luenced by
many d**erent *orces1 )th the e**ects and the relat0e m-ortance o* the d**erent n*luences
contnuously chan!n! as condtons chan!e. .o the e%tent that trade *lo)s are a *orce n the
mar'et1 com-ett0eness s ob0ously m-ortant to the e%chan!e rate1 and the many *actors
a**ectn! com-ett0eness must be consdered..o the e%tent that the money mar'et s a *actor1 the
*ocus should be on short:term nterest rates1 and on monetary -olcy and other *actors
n*luencn! those shortterm nterest rates. .o the e%tent that -ort*olo ca-tal *lo)s matter1 the
*ocus should be broadened to nclude bond mar'et condtons and lon!:term nterest rates.
Fartcularly at tmes o* !reat nternatonal tenson1 all other *actors a**ectn! the dollar e%chan!e
rate may be o0er)helmed by consderatons o* "sa*e ha0en.(
8ndeed1 countless *orces n*luence the e%chan!e rate1 and they are sub/ect to contnuous and
un-redctable chan!es o0er tme1 by a mar'et that s broad and hetero!enous n terms o* the
-artc-ants1 ther nterests1 and ther tme *rames.
Wth condtons al)ays chan!n!1 the m-act o* -artcular e0ents and the res-onse to -artcular
-olcy actons can 0ary !reatly )th the crcumstances at the tme. H!her nterest rates m!ht
stren!then a currency or )ea'en t1 by a small amount or by a lotOmuch de-ends on )hy the
nterest rates )ent u-1 )hether a mo0e )as antc-ated1 )hat subse<uent mo0es are e%-ected1
and the m-lcatons *or other *nancal mar'ets1 decsons1 or !o0ernment -olcy mo0es.
Smlarly1 the results o* e%chan!e rate chan!es are not al)ays -redctable3 8m-orters m!ht
e%-ect to -ay more * ther domestc currency de-recates1 but not * *ore!n -roducers are
24
"-rcn! to mar'et( n order to establsh a beachhead or mantan a mar'et share1 or * the
m-orters or e%-orters had antc-ated the rate mo0e and had acted n ad0ance to -rotect
themsel0es *rom t.
Gonetheless1 those -artc-atn! n the mar'et must ma'e ther *orecasts1 m-lctly and
e%-lctly1 day a*ter day1 all o* the tme. $0ery -ece o* n*ormaton that becomes a0alable can be
the bass *or an ad/ustment o* each -artc-ants 0e)-ont1 or e%-ectatonsOn other )ords1 a
*orecast1 n*ormal or other)se. When the screen *lashes )th an une%-ected announcement that1
say1 +ermany has reduced nterest rates by a <uarter o* one -ercent1 that s not /ust ne)s1 t s the
bass *or countless assessments o* the s!n*cance o* that e0ent1 and countless *orecasts o* ts
m-act n number o* bass -onts.
.hose )ho *orecast *ore!n e%chan!e rates o*ten are d0ded nto those )ho use "techncal(
analyss1 and those )ho rely on analyss o* "*undamentals1( such as +4F1 n0estment1 sa0n!1
-roduct0ty1 n*laton1 balance o* -ayments -oston1 and the l'e.
.echncal analyss assumes certan short:term and lon!er:term -atterns n e%chan!e rate
mo0ements. 8t d**ers *rom the "random )al'( -hloso-hyOthe bele* that all -resently a0alable
n*ormaton has been absorbed nto the -resent e%chan!e rate and that1 the ne%t -ece o*
n*ormaton as )ell as the drecton o* the ne%t rate mo0e s random1 )th a 50 -ercent chance
the rate )ll rse1 and 50 -ercent chance t )ll declne.
25

Gearly all traders ac'no)led!e ther use o* techncal analyss and charts. 2ccordn! to sur0eys1 a
ma/orty say they em-loy techncal analyss to a !reater e%tent than "*undamental( analyss1 and
26
that they re!ard t as more use*ul than *undamental analyssOa contrast to t)enty years a!o
)hen most sad they reled many more hea0ly on *undamental analyss.
Ferha-s traders use techncal analyss n -art because1 at least su-er*cally1 t seems sm-ler1 or
because the data are more current and tmely. Ferha-s they use t because traders o*ten ha0e a
0ery short:term tme *rame and are nterested n 0ery short:term mo0es. .hey m!ht a!ree that
"*undamentals( determne the course o* -rces n the lon! run1 but they may not re!ard that as
rele0ant to ther mmedate tas'1 -artcularly snce many "*undamental( data become a0alable
only )th lon! la!s and are o*ten sub/ect to ma/or re0sons. Ferha-s traders thn' techncal
analyss )ll be e**ect0e n -art because they 'no) many other mar'et -artc-ants are relyn!
on t. Stll1 s-ottn! trends s o* real m-ortance to tradersO"a trend s a *rend( s a comment
o*ten heardOand techncal analyss can add some dsc-lne and so-hstcaton to the -rocess o*
dsco0ern! and *ollo)n! a trend.
.echncal analyss may add more ob/ect0ty to ma'n! the d**cult decson on )hen to !0e u-
on a -ostonOenabln! one to see that a trend has chan!ed or run ts course1 and t s no) tme
*or reconsderaton.
&ost mar'et -artc-ants -robably use a combnaton o* both *undamental and techncal analyss1
)th the em-hass on each sh*tn! as condtons chan!eOthat s1 they *orm a !eneral 0e) about
)hether a -artcular currency s o0er0alued or under0alued n a structural or lon!er:term sense1
and )thn that lon!er:term *rame)or'1 assess the order *lo) and all current economc *orecasts1
ne)s e0ents1 -oltcal de0elo-ments1 statstcal releases1 rumors1 and chan!es n sentment1 )hle
also care*ully studyn! the charts and techncal analyss.
26
,%%i#ia$ a#tions to in%$uen#e ex#hange rates
2s n some other ma/or ndustral natons )th *loatn! e%chan!e rate re!mes1n the Anted
States there s consderable sco-e *or the -lay o* mar'et *orces n determnn! the dollar
e%chan!e rate.,ut also1 as n other countres1A.S. authortes do ta'e ste-s at tmes to n*luence
the e%chan!e rate1 0a -olcy measures and drect nter0enton n the *ore!n e%chan!e mar'et to
buy or sell *ore!n currences.2s noted abo0e1 n -ractce1 all *ore!n e%chan!e mar'et
nter0enton o* the A.S. authortes s routnely sterl@edOthat s1 the ntal e**ect on A.S. ban'
reser0es s o**set by monetary -olcy acton.
Go one <uestons that monetary -olcy measures can n*luence the e%chan!e rate by a**ectn! the
relat0e attract0eness o* a currency and e%-ectatons o* ts -ros-ects1 althou!h t s d**cult to
*nd a stable and s!n*cant relatonsh- that )ould yeld a -redctable1 -recse res-onse. ,ut the
<ueston o* the e**ect0eness o* sterl@ed nter0enton1 )hch has been e%tens0ely studed and
debated1 s much more contro0ersal. Some economsts contend that sterl@ed nter0enton can
ha0e1 at best1 a modest and tem-orary e**ect. 5thers say t can ha0e a more s!n*cant e**ect by
chan!n! e%-ectatons about -olcy and hel-n! to !ude the mar'et. Stll others bele0e that the
e**ect de-ends on the -artcular mar'et condtons and the nter0enton strate!y o* each stuaton.
+0en the -resent s@e o* A.S. monetary a!!re!ates1 balance o* -ayments *lo)s1 and the le0els o*
act0ty n the *ore!n e%chan!e mar'et and other *nancal mar'ets1 t s )dely acce-ted that any
e**ects o* sterl@ed nter0enton are l'ely to be throu!h ndrect channels rather than throu!h
drect m-act on these lar!e a!!re!ates. $m-rcal tests o* sterl@ed nter0enton ha0e *ocused on
t)o man channels throu!h )hch such nter0enton m!ht ndrectly n*luence the e%chan!e rate3
the -ort*olo balance channel and the e%-ectatons1 or s!naln!1 channel..
.he -ort*olo balance channel -ostulates that the e%chan!e rate s determned by the balance o*
su--ly and demand *or a0alable stoc's o* *nancal assets held by the -r0ate sector. 8t holds that
sterl@ed nter0enton )ll alter the currency com-oston o* assets a0alable to the !lobal -r0ate
sector1 and that * dollar and *ore!n currency:denomnated assets are 0e)ed by n0estors as
m-er*ect substtutes1 sterl@ed nter0enton )ll cause mo0ements n the e%chan!e rate to
ree<ulbrate su--ly and demand *or dollar assets. .he s@e o* ths -ort*olo balance e**ect )ould
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de-end on the de!ree o* substtutablty bet)een assets denomnated n d**erent currences and
on the s@e o* the nter0enton o-eraton.
.he e%-ectatons1 or s!naln!1 channel holds that sterl@ed nter0enton may cause -r0ate
a!ents to chan!e ther e%-ectatons o* the *uture -ath o* the e%chan!e rate. .hus1 nter0enton
could s!nal n*ormaton about the *uture course o* monetary or other economc -olces1 s!nal
n*ormaton about1 or analyss o*1 economc *undamentals or mar'et trends1 or n*luence
e%-ectatons by a**ectn! techncal condtons such as bubbles and band)a!ons.
2 consderable number o* studes ha0e *ound no <uanttat0ely m-ortant e**ects o* sterl@ed
nter0enton throu!h the -ort*olo balance channel. Some studes ha0e *ound e%-ectatons or
s!naln! e**ects o* 0aryn! de!rees o* s!n*cance. 5thers conclude that the e**ect0eness
de-ends 0ery much on mar'et condtons and nter0enton strate!y.
.here are serous data and econometrc -roblems n studyn! ths <ueston. .o assess success1 the
researcher needs to 'no) the ob/ect0e o* the nter0enton and other s-ec*c detalsO)as the
am to amelorate a trend1 sto- a trend1 re0erse a trend1 sho) a -resence1 calm a mar'et1
dscoura!e s-eculaton1 or buy a lttle tme; .he researcher also needs to 'no) the counter*actual
O)hat )ould ha0e ha--ened * the nter0enton had not ta'en -lace. 2lso1 research on ths ssue
must be -laced n the broader conte%t o* research on e%chan!e rate determnaton1 )hch noted
abo0e1 ndcates that t has not been -ossble to *nd stable and s!n*cant relatonsh-s bet)een
e%chan!e rates and any economc *undamentals.
2s a -ractcal matter1 t s d**cult to ma'e s)ee-n! assessments about the success or *alure o*
o**cal nter0enton o-eratons. Some nter0enton o-eratons ha0e -ro0en resoundn!ly
success*ul1 )hle others ha0e been dsmal *alures.
.he success or *alure o* nter0enton s not so much a matter o* statstcal -robablty as t s a
matter o* ho) t s used and )hether condtons are a--ro-rate. 8s the ob/ect0e reasonable;
4oes the mar'et loo' techncally res-ons0e; 8s nter0enton antc-ated; Wll an o-eraton loo'
credble; What s the l'ely e**ect on e%-ectatons;
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8n 19831 the Wor'n! +rou- on #ore!n $%chan!e &ar'et 8nter0enton establshed at the
Lersalles summt o* the +rou- o* Se0en )arned a!anst e%-ectn! too much *rom o**cal
nter0enton1 but concluded that such nter0enton can be a use*ul and e**ect0e tool n
n*luencn! e%chan!e rates n the short run1 es-ecally )hen such o-eratons are consstent )th
*undamental economc -olces.
An<uestonably1 nter0enton o-eratons are more l'ely to succeed )hen there s a consstency
)th *undamental economc -olces1 but t may not al)ays be -ossble to 'no) )hether that
consstency e%sts.
2lthou!h atttudes d**er1 monetary authortes n all o* the ma/or countres nter0ene n the
*ore!n e%chan!e mar'ets at tmes )hen they consder t use*ul or a--ro-rate1 and they are
l'ely to contnue to do so. .he current atttude to)ard *ore!n e%chan!e mar'et nter0enton s
summar@ed n the *ollo)n! e%cer-t *rom the =une 1996 re-ort o* the *nance mnsters o* the
+rou- o* Se0en natons3
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1$exib$e v7s %ixed ex#hange rates
$%chan!e rates stablty has al)ays been the ob/ect0e o* monetary -olcy o* almost all countres.
$%ce-t durn! the -erod o* !reat de-resson and )orld )ar88 1 the e%chan!e rate ha0e been
almost stable.durn! the -ost: )ar 88 -erod 1 the 8&# had brou!ht a ne) -hase o* e%chan!e rate
stablty.
&ost !o0ernments ha0e mantaned ad/ustable *%ed e%chan!e rates tll 1963. ,ut the 8&#
system *aled to -ro0de an ade<uate soluton to three ma/or -roblems causn! e%chan!e
nstablty:
1. Fro0dn! su**cent reser0es to mt!ate the short term *luctuatons n the balance o* -ayments
)hle mantann! the *%ed e%chan!e arte system.
2. Froblems o* lon! term ad/ustments n the balance o* -ayments.
3. Frces !enerated by s-eculat0e transactons.
#or these reasons the currences o* many countres 1 es-ecally the reser0e currency )ere sub/ect
to *re<uent de0aluaton n the early 19601s. ths rased doubts about the -ossblty o* the
,retten)ood1s system1and also about the 0ablty o* the *%ed e%chan!e rate system. .he
brea'do)n o* ,retton)ood system !enerated a debate on )hether *%ed or *le%ble e%chan!e rate
should be used.Q
.he man ar!uments n *a0our o* *%ed e%chan!e rates are:
Firstly1#%ed e%chan!e rate -ro0des stablty n the *ore!n e%chan!e mar'et and certanty about
the *uture course o* the e%chan!e rate and t elmnates rs's caused by uncertanty due to
*luctuatons n the e%chan!e rates. .he stablty o* e%chan!e rate encoura!es nternatonal
trade.on the contrary1 *le%ble e%chan!e rate system causes uncertanty and m!ht also o*ten lead
to 0olent *luctuatons n nternatonal trade. 2s a result *ore!n trade orented economes become
sub/ect to se0ere economc *luctuatons1 * m-ort elastctes are less than e%-ort elastctes.
Secondly 1 the *%ed e%chan!e rate system creates condtons *or smooth *lo) o* nternatonal
ca-tal sm-ly because t ensures a certan return on the *ore!n n0estment. Whle n the case o*
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*le%ble e%chan!e rate1 ca-tal *lo)s are constraned because o* uncertanty about e%-ected rate
o* return.
Thirdly, the *%ed rate elmnates the -ossblty o* s-eculaton1 )hereby t remo0es the dan!ers
o* s-eculat0e act0tes n the *ore!n e%chan!e mar'et. 5n the contrary *le%ble e%chan!e rates
encoura!e s-eculaton.
Fourthly , the *%ed e%chan!e rate system reduces the -ossblty o* com-ett0e de-recaton o*
currences as t ha--ened durn! 1930s. also1 de0atons *rom *%ed rate are easly ad/ustable.
Fifthly1 a case s also made n *a0our o* *%ed e%chan!e rate on the bass o* e%stence o* currency
areas. .he *le%ble e%chan!e rate s sad to be unsutable bet)een the natons )hch consttute a
currency area1 snce t leads to a chaotc stuaton and hence ham-ers trade bet)een them.
.he man ar!uments n *a0our o* *le%ble e%chan!e rates 3
Firstly, *le%ble e%chan!e rate system -ro0des lar!er de!ree o* autonomy n res-ect o* domestc
economc -olces as t s not obl!atory *or the coutres to tune ther domestc -olces to *%ed
*ore!n e%chan!e rate.
Secondly1 *le%ble e%chan!e rate s sel* ad/ustn! and there*ore t does not de0ol0e on the
!o0ernment to mantan an ade<uate *ore!n e%chan!e reser0e.
Thirdly, the *le%ble e%chan!e rate1 )hch s determned by mar'et *orces1 has a theory behnd t
and has the <ualty o* -redctablty.
Fourthly1 *le%ble e%chan!e rates ser0e as a barometer o* the actual -urchasn! -o)er and
stren!th o* a currency n the *ore!n e%chan!e mar'et. 8t ser0es as a use*ul -arameter n the
*ormulaton o* the domestc economc -olces.
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Fifthly, economsts ha0e also ar!ued that the most serous char!e a!anst *luctuatn! e%chan!e
rate .e. unceratnty s not tenable because s-eculators themsel0es create condtons *or e%chan!e
rate stablty. 2lso1 the de!ree o* uncertanty assocated )th *le%ble e%chan!e rate could not be
much !reater then )hat the )orld has e%-erenced )th ad/ustable *%ed e%chan!e rate under the
bretton)oods system.
.he debate on *%ed 07s *le%ble e%chan!e rate s nconclus0e . n*act1 both systems ha0e ther
o)n merts and demerts.
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Bib$iography
,oo's :
1. &ana!eral $conomcs by 4.G. 4)0ed.
2. &ana!eral $conomcs by Ehatur0ed.
3. &acroeconomcs by R.H.&sra
4. &acroeconomcs by &.B. Seth
Stes C
))).*ore%.com
))).moneyn0estment.com
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