Sixth Chapter

The Role of Government in Exchange Rate Determination

12th lecture

Introduction

Government is a key player in foreign exchange market today because of its size as compared to
other market participant and thus it can influence the equilibrium in many ways. It influences
equilibrium both directly by direct interventions in its forex market using its central bank arm as
well as indirectly by affecting the macroeconomic variables. Direct interventions can both be
through regulations as well as through buying and selling of currencies and indirect interventions
are mainly through its fiscal spending arm. Within its interventionist perspective we can find the
following forex exchange systems prevailing at different levels at different countries.

i. Fixed float
ii. Managed float
iii. Pegged float
iv. Open market float or freely floating exchange rates

Fixed Float

In finance the word float is referred to the amount of money that is allowed by the central bank
to circulate in the economy. Fixed float refers to the system of exchange rates where the rate of
exchange of different currencies with respect to each other is fixed over time or it is allowed to
fluctuate in a very narrow bracket. Fixed exchange rate system is not found today however
historically it has been prevailing globally after the World War II in years 1944 till 1971. In this
era all countries and their central banks fixed their currency values in terms of fixed amount of
gold looking to the gold market in their respective domestic gold markets. dollar for example
was fixed at 35th of an ounce of gold and similarly other currencies and no country’s central bank
would float paper money notes in its economy unless it was backed by that specific amount of
gold reserves with its central bank. Therefore, each currency was fixed in value related to each
other currency keeping it fixed gold rate in mind. This era is called gold era and it lasted for
about 26 years. (see history of fixed exchange rate system in Europe and later on abolition of the
this exchange rate system as your homework).

Fixed exchange rate system has major advantage of foreign exchange rate risk elimination for
MNCs. MNCs most transactions involve interaction in the forex market and its revenues do
fluctuate due to forex rates of their host countries however if these rates are fixed then a major
risk coming from forex market vanishes and only their business risk coming from their foreign
facilities remains.

Fixed exchange rate system however carries a major disadvantage as economic conditions in one
country may be shifted into other countries which are major trading partners. For example if
inflation in US increases relatively to the inflation in UK and their exchange rates are fixed then
prices of goods in US will be relatively more than the prices of goods in UK keeping the relative
purchasing power as given then people’s demand in US for UK goods and people’s demand in
UK for UK goods would increase which will exert upwards pressure on prices in UK and thus
inflation in US will be shifted to UK. Similar will be the case for other macroeconomic variables.

Freely Floating Exchange Rate System

In the fixed exchange rate system it was felt that US dollar was fixed at heavier rate than others
which was resulting in US’s trade deficit. Heavier currency means the price of goods in terms of
other currency in other countries are high which means less export and more imports which
means high trade deficit. Therefore, meeting was arranged to discuss a more realistic dollar rate
of exchange so that US good become more competitive in the international market. In 1971 the
meeting among the officials of the countries reached to an agreement called Smithsonian
agreement in which the dollar was devalued by 8 percent and bracket too was widened to 2.25
however the imbalances among currency rates continued which resulted in 1973 the
abandonment of fixed exchange rate system.

Freely floating exchange rate system ideally does not exist anywhere. It is an exchange rate
system in which no intervention is allowed in forex market whereupon forex rates occur fully
under the forces of supply and demand. It is a system of exchange rate therefore where rates
exhibit a random walk where market is fully information efficient and forex rates reflect true
market fundamentals.

Freely floating exchange rate system has the advantage of exchange rate being fully random and
thus unmanipulable where upon any changes in the economic performance of a country are
reflected in the value of its currency in its forex market and thus the potential of shifting of one
country economic performance to its trade partners diminishes. Taking lead from the previous
example if the inflation in US increases means its economic performance is not good means the
value of its currency should decrease and that what happens which we have freely floating forex
system. The increase in prices of goods produced in US will lead to its decreased domestic and
international demand and the decrease demand for dollars which will be reflected in the dollar’s
depreciation and macroeconomic conditions of US limited to US only.

Disadvantage of free float is that currency values will be fully random and thus unpredictable
which means MNCs focusing on information asymmetries in forex market and thus finding any
possible patterns in past rates to predict future rates and minimize their risk. Furthermore, the
economic problems of one country are not shifted to its trading partners but freely floating
system can exacerbate the economic problems of that country. The weakening of dollar for
example can increase the import prices of US and thus the production costs which may further
increase the inflation in US.

Managed Float

Managed float is a system of mixing two approaches to foreign exchange market; it combines
features of free float and mixed float to giving rise to a system of freedom-cum interventionist
foreign exchange market. It is a system where central bank allows the float to flow freely but
also intervenes at times when the market becomes unexpectedly volatile. It intervenes when the
forex rates move outside an imaginary bracket presumed as suitable by the central bank in those
economic conditions or when the central banks sees the rates are moving abruptly and need to be
smoothed out. Managed float is what a forex system prevailing in most countries today. Forex
rates are central to a country’s trade i.e. foreign exchange inflows and thus a source of political
and economic controversies among the countries leading the foreign trade. Such countries keenly
watch their rates compared to their economic competitors and thus manipulate their forex
markets trying to protect their local producers and creating attractions for forex inflows.

We do hear in the news that US attacks China by saying it is artificially/intentionally keeping

Yuan lighter while China complaining about US of tariffs and other trade embargos. Similar,
tensions arise in Canada with the US these days as well as among other trade partners partially
caused by the political/philosophical differences too. Managed float is therefore the norm today
one cannot practically find free markets within the arena of foreign exchange and international
trade.

Pegged Float/Currency Boards

Pegged float is naturally the fixed float discussed above however in the fixed float there is an
overt agreement among the countries that they will honor the rate of exchanged fixed by them
through the actions of the central banks’ interventions in their markets if the rate of exchange is
altered by the open market forces from that which is fixed by them. For example if it is agreed
between US and UK that the rate exchange 1pound = 1.50 dollars then all of the actions of these
two central bank will watch and focus on maintaining this forex rate and if pounds gets heavier
Bank of England will correct it and/or Federal Reserves will correct it. In the pegged float
however there is no overt agreement among the countries that their forex rate will be fixed rather
only a given central bank of country overtly communicates to the forex market a rate of its
currency with another more stable and strong currency (i.e. dollar) which it will always honor
and always achieve for its currency in its forex market. Thus in pegged system only one
country’s central bank takes this burden completely on its own that it will honor an exchange rate
of its currency with another stable currency while other central bank does not have any official
obligation that it will also honor that fixed rate. Thus in a pegged relation it is only monetary
policy of a given central bank and the forex market is well aware of the peg rate and it keeps in
mind the pegged rate while making its international payments’ decisions.

Since a peg is a one-sided relation where the central bank to which a given currency is pegged is
under no official obligation to honor the peg therefore it solely depends upon the capacity of the
central bank which is pegging its currency to honor its peg in all situations. By the capacity of
the central bank we mean that having and maintaining the amount of the foreign exchange
reserves which is deemed as sufficient by the market to honor the peg the central bank is overtly
promising. If for some reasons in some situations current and/or expected outflows of foreign
exchange are deemed by the market to be well above the actual and/or expected level of reserves
with the central bank there will be a big question mark on the capacity of the central bank to
maintain the bank and market will thus start to speculate about the break of the peg. The
breakage of peg and the market’s abrupt flight can be a very big cause of risk for the currency
which is being pegged.

Thus the peg is good strategy in times when central bank possess huge level of foreign reserves
and its net exports are major source of foreign exchange inflows so that it has a realistic
dependable capacity for maintaining its peg in difficult situations. Pegged currency enjoys the
stability of stability of currency which is enjoyed by the stable currency to which it is pegged and
thus a realistic peg can be a very good source of DFIs and other sources of foreign exchange
inflows. Market does respond to a realistic peg in positive manner and thus pegged forex rate can
be source of economic development however its negative sides are dangerous too. The peg
becomes dangerous when government borrows in the foreign currency in high volumes and/or
when companies in the economy borrow in foreign currency and there are other payment
obligations denominated in the foreign currency so that there is comparatively more payment
outflows in the future than expected level of reserves levels/inflows with central bank. Therefore,
the market will start speculating about the broken peg and thus a flight from the currency.

See the case of the European Snake and other pegged arrangements from the book as your
homework. Furthermore, we can identify Afghanistan’s currency being pegged by its central
bank with the dollar which is being backed unofficially by Federal Reserves too as an example of
pegged foreign exchange market today.

When a central bank pegs its currency with another currency it loses its freedom over its
domestic interest rates as well as it is exposed to the adverse movements in exchange rates of
other currencies also. If the interest rate in the economy of the currency to which a currency is
pegged increases the pegged currency central bank must also increase the interest rates
irrespectively of the fact regarding the conditions prevailing in its economy thus creating a
potential source of risk. Similarly, since a currency can be pegged to only one currency at a time
therefore pegging a currency can expose the currency to adverse movements of other currency
rates.
Government Intervention

Government can intervene in its forex market two in ways. One is called direct intervention
while the other is called indirect intervention. Direct intervention itself can be divided into two
categories; Sterilized intervention and non-sterilized intervention.

Before we discuss the actions of government which affect its forex market we need to know why
government intervene its forex market. Government intervenes in its forex market for three
purposes. 1. To smooth exchange rate movements 2. Establish implicit exchange rate boundaries
and 3. To respond to temporary disturbances.

Exchange rate is not a constant rather it is a market based variable therefore it will have to
change with time and thus some moderate level volatility is tolerated by the central bank and is
considered normal. However, when there are movements in exchange rates which are not
considered as normal the central bank becomes a party in this market where it buys and sells
currencies so that huge unexpected movements are smoothed out. 2. In other situations central
bank would intervene in its forex market when it wants to establish implicit maximum and
minimum bounds for its exchange rate in minds of its forex market. In this way the central bank
gives some surety of less and high predictability of its forex rates and thus MNCs would be at
ease doing their international transactions. Lastly, there are sometimes economic shocks within
ones economy or in other markets which can result in temporary tensions in forex market. As
result market can become suddenly bearish creating huge disturbances in the exchange rate. The
central bank will monitor the market for such crises situations not to frighten away forex market.

Direct Intervention

For direct intervention the central bank should have the capacity to manipulate the market. By
capacity we mean central bank should have the required inventory of desired currency which it
will use to complete its transactions in its forex market. If the central bank does not possess the
capacity then will not have the required monetary power to bring the equilibrium rate to the level
it wants to. Developing and under developed economies having central banks which are weak
with respect to their capacity face the same problem. Their forex markets are out of their control
and which sometime result in their economy fall into hyper inflations.

For developed capitalist world the life the central bank ia so easy. When it feels its currency is
either overvalued or undervalued it moves in. to counter the situation of heavy dollar for example
the fed will sell dollars and buy the desired currency which it wants to appreciate and to counter
the situation of lighter dollar it will do the vice versa. Since, the central bank will be a huge actor
in the forex market will become oligopoly and thus equilibrium rate will be brought to the
desired level.

Sterilized Intervention/Non-sterilized Intervention

By sterilized intervention we mean central bank neutralizing its actions in the forex market by
performing monetary actions in Federal Reserve market. For if US fed sells dollars in its forex
market to weaken it will result in the excessive of money in its economy and thus it will distort
its money supply targets. To keep the money supply at the budgeted levels and save the economy
from overheating and it will buy the dollars from the federal reserves of the commercial banks by
selling T-bills. Thus increased supply of dollars in the forex market will be neutralized by
decreased supply reserves in the reserves market and the intervention will become sterilized one.
Similarly, to perform the non-sterilized intervention the central bank will not neutralized the
effect of its intervention in the forex market by its actions in the federal reserve market.

Indirect Intervention

The route of indirect intervention is not through the central banking arm of the government
rather it comes indirectly through the macroeconomic effects of the government fiscal and
spending arms. Government as a huge developmental spender through its different ministries can
stir different markets in the economy which in return can change the macroeconomic posture of
the economy and thus its forex market. Similarly, government through its tax policy can affect
the purchasing power of people and thus its markets which will result in changing overall
economic indicators. This section repeats discussion from chapter number 4.

Similarly, government can influence the interest rates in the economy and it can implement the
forex exchange controls though its prudential regulations and disciplining its commercial banks
and airports and money exchangers which will indirect effects on its forex market.

Intervention as Policy Tool

Direct intervention is sometimes referred to temporary short term intervention which affects the
forex rate only artificially. Similarly, the effects of direct interventions are sometimes countered
by other governments as well by company actions which leave central bank interventions in its
forex market as futile. The critics therefore state that government should resort to indirect
interventions which through the role of government’s actions in real economy and leave
permanent effects on the equilibrium exchange rates.

In modern day economies the forex rate has become an important policy tool for the government
like its laws and monetary policy which it can manipulate to achieve its desired objectives for the
economy. The effects of weak currency on exports are very positive as it enhances employment
in the economy and reduces imports resulting in huge forex inflows into the economy. It
however has the potential to increase inflation in the economy. Similarly, the effect of the strong
currency has the opposite effects. It increase imports and reduces exports but can reduce
domestic inflation.

All of the government interventions therefore will have to be prudent enough that results in
positive outlook for the economy and with less inflationary risks and stable currency.