Foreign exchange market

Contents Topic
1. Foreign exchange market: An introduction 2. Foreign exchange instruments. 3. Factors influencing Exchange rates 4. Determination of Exchange Rates 5. Foreign Exchange Forecasting in !ractice #. $fficial Actions to influence Exchange Rates %. Flexi&le '(s Fixed Exchange rates ).*i&liogra!h+

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The Foreign Exchange Market: An introduction

What is foreign exchange rate or exchange rate? 1

An exchange rate is sim!l+ the !rice of one currenc+ in terms of another. ,he !rocess &+ -hich that !rice is determined de!ends on the !articular exchange rate mechanism ado!ted. .n a floating rate s+stem/ the exchange rate is determined directl+ &+ market forces/ and is lia&le to fluctuate continuall+/ as dictated &+ changing market conditions. .n a 0fixed0/ or managed rate s+stem/ the authorities attem!t to regulate the exchange rate at some le'el that the+ consider a!!ro!riate. 1uch a s+stem often seems a!!ealing to those -ho are trou&led &+ the uncertainties of the !resent/ highl+ 'olatile/ floating rate en'ironment. *ut the choice of exchange rate regime in'ol'es considerations that extend &e+ond the sta&ilit+ or other-ise of currenc+ !rices. ,his -ill &ecome clearer after an examination of some fundamentals of the foreign exchange market. Economics of the Foreign Exchange Market .n a floating exchange rate regime the !rice of the dollar/ like an+ other market2determined !rice/ de!ends on the rele'ant forces of su!!l+ and demand. *ut -hat are the rele'ant forces of su!!l+ and demand in the foreign exchange market3 ,o tr+ to ans-er this 4uestion/ let us consider/ for illustration/ the factors that determine the relationshi! &et-een the Australian dollar and the 5a!anese +en. ,he 5a!anese re4uire dollars to !a+ for their im!orts of goods and ser'ices from Australia and to fund an+ in'estment the+ ma+ -ish to undertake in this countr+. Assume that the+ o&tain these dollars on the foreign exchange market &+ su!!l+ing 6selling7 +en in return. 1o the 5a!anese demand for dollars 6mirrored &+ the su!!l+ of +en7 is determined &+ the ex!orts to 5a!an and our ca!ital inflo- from that countr+. $n the other side of the market/ the Australian demand for +en is determined &+ our need to !a+ for im!orts from 5a!an/ and for an+ ca!ital in'estment that -e undertake there. 8e &u+ those +en &+ su!!l+ing Australian dollars in return. ,hus the su!!l+ of dollars 6mirrored &+ the demand for +en7 is determined &+ our im!orts from 5a!an and our ca!ital outflo- to that countr+. .n summar+/ then/ the demand for Australian dollars reflects the &eha'ior of our ex!orts and ca!ital inflo-/ -hile the su!!l+ of dollars reflects the &eha'ior of our im!orts and ca!ital 2

outflo-. .n other -ords/ transactions on the foreign exchange market echo the international trade and financial transactions that are summari9ed in the &alance of !a+ments. 8ithin the &alance of !a+ments/ the relationshi! &et-een our ex!orts and im!orts of goods and ser'ices is ca!tured &+ the &alance of current account/ -hile the relationshi! &et-een ca!ital inflo- and ca!ital outflois ca!tured &+ the &alance of ca!ital account. ,he acti'ities of international currenc+ s!eculators affect the exchange rate directl+ through their im!act on ca!ital flo-s. ,he distinguishing characteristic of a floating exchange rate s+stem is that the !rice of a currenc+ ad:usts automaticall+ to -hate'er le'el is re4uired to e4uate the su!!l+ of and demand for that currenc+/ there&+ clearing the market. ,he logic of the relationshi! &et-een our international transactions and the su!!l+ and demand for currencies im!lies that this market2clearing/ or 0e4uili&rium0/ !rice also !roduces automatic e4uili&rium in the &alance of !a+ments. ,hat is/ the &alance of current account 6-hether !ositi'e/ negati'e/ or 9ero7 must &e !recisel+ offset &+ the &alance 6negati'e/ !ositi'e/ or 9ero7 of the ca!ital account. ;nder floating exchange rates these outcomes are achie'ed automaticall+ -ithout the need for go'ernment inter'ention. *+ contrast/ under fixed exchange rates &alance of !a+ments e4uili&rium is not the normal condition. ,hese characteristics of the floating exchange rate mechanism ha'e im!ortant im!lications &oth for the nature of our relationshi! -ith the glo&al en'ironment/ and for the !olic+ o!tions a'aila&le to the authorities in managing the econom+. <et us no- consider some of these.

Internationa Transmission of Economic !ta"i it#

A flexi&le exchange rate acts as a kind of shock a&sor&er that hel!s to insulate us against o'erseas distur&ances. ,his is &ecause the relationshi! &et-een our international transactions and the foreign exchange market runs in &oth directions. <et us su!!ose/ for exam!le/ that recession in the 5a!anese econom+ leads to a decline in the demand for Australian ex!orts. .n itself/ this -ill tend to reduce economic acti'it+ in Australia. *ut this tendenc+ -ill &e offset &+ an associated de!reciation of the dollar/ -hich -ill induce an ex!ansion of ex!orts/ a contraction of im!orts/ and !erha!s an increase in net ca!ital inflo-/ all of -hich -ill hel! to cushion the Australian econom+ against recession. An analogous mechanism -ould o!erate to reduce the im!act of an initial decline in 5a!anese in'estment in Australia. *oth cases illustrate the role of exchange rate flexi&ilit+ in insulating our econom+ to some degree against international economic insta&ilit+. *+ the same reasoning/ floating exchange rates also hel! to diminish the international transmission of our o-n domestic economic insta&ilit+. Characteristics of the Foreign Exchange Market ,he Forex market does not exist !h+sicall+/ it is a frame-ork -here !artici!ants are connected &+ com!uters/ tele!hones and telex 618.F,7 and o!erates in most financial centres glo&all+. *ecause the Forex market is so highl+ integrated glo&all+/ it can o!erate 24 hours a da+ = -hen one ma:or market is closed/ another ma:or market is o!en to facilitate trade occurring 24 hours a da+ mo'ing from one ma:or market to another. >ost exchanges of currenc+ are made through &ank de!osits i.e. transferred electronicall+ from one account to another. ,he 'olume of foreign exchange transactions -orld-ide is assumed to &e a!!roximatel+ ;1D 2 trillion !er da+. ,he a'erage dail+ turno'er in the 1outh African market is R11 &illion !er da+ and 1tandard *ank is the recognised leader in the domestic foreign exchange market/ handling more than 3 ? of 1outh Africa0s foreign exchange 'olume. ,he Forex market is an o'er2the2 counter market i.e. trading in financial instruments that are not listed or a'aila&le on an officiall+ recognised exchange 6such as the 51E = 5ohannes&urg 1tock Exchange7/ &ut traded in direct negotiation &et-een &u+ers and sellers. ,rading takes !lace tele!honicall+ or electronicall+.

Wh# do $e make use of the Foreign Exchange Market? 4

,rading in a domestic market is su&stantiall+ different from doing &usiness in an offshore market. .n the com!lex -orld of international trade/ merchants face a num&er of risks that need to &e managed in order to ensure the success of their cross = &order transactions. .n order to !rotect themsel'es/ these cor!orations a!!l+ hedging techni4ues using 'arious foreign exchange instruments and !roducts in order to negate the im!acts of exchange rate fluctuations. 1uccessful com!anies em!lo+ effecti'e risk management techni4ues -hen making &usiness decisions/ and e'aluate commercial risk in an ex!licit and logical manner in order to offset financial loss occasioned &+ the 'olatilit+ in exchange rates 6currenc+ risk7. Who are the Foreign Exchange Market Participants? @ommercial *anks !artici!ate in the market &+ offering to &u+ and sell foreign exchange on &ehalf of their retail or -holesale customers as a !art of their financial ser'ice. ,he+ also trade in foreign exchange as an intermediar+ and market maker. 6A market maker 4uotes a &u+ and sell !rice on a currenc+ or financial instrument ho!ing to make a !rofit on the s!read i.e. the difference &et-een the &u+ing and the selling !rice7. $ther financial .nstitutions/ such as *rokers 6.nstitutional .n'estors/ .nsurance com!anies/ Aension/ >utual and Bedge Fund >anagers7 need to manage 'arious !ortfolios on &ehalf of their clients/ and thus !artici!ate in the foreign exchange market. ,he+ rel+ on the rates 4uoted &+ the market makers to market !artici!ants and charge commission or a &rokerage fee for ser'ices rendered. @or!orations &u+ and sell foreign exchange generall+ to facilitate trade/ or as a result of a trade done and also to hedge currenc+ ex!osures that exist due to a !articular trade conducted. ,hese cor!orations generall+ consist of ex!orters and im!orters. @entral *anks can sometimes inter'ene in the foreign exchange market in order to im!lement monetar+ !olicies.

Foreign Exchange Instruments

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A num&er of foreign exchange instruments ha'e &een designed for effecti'e hedging as -ell as enhancement of returns. ,he follo-ing instruments and !roducts are most common to the Foreign Exchange >arket to facilitate international trade and -ill &e co'ered in future Forex *ulletins: 1!ot transactions/ For-ard ,ransactions 6FE@Cs7/ $!tions 6Deri'ati'es of exchange rates7/ .nternational mone+ transfers/ Duarantees/ @ommercial @ustomer Foreign @urrenc+ accounts/ Documentar+ @redit and @ollections/

Factors inf uencing exchange rates

Foreign exchange rates are extremel+ 'olatile and it is incum&ent on those in'ol'ed -ith foreign exchange 2 either as a !urchaser/ seller/ s!eculator or institution 2 to kno- -hat causes rates to mo'e. Actuall+/ there are a 'ariet+ of factors 2 market sentiment/ the state of the econom+/ go'ernment !olic+/ demand and su!!l+ and a host of others. ,he more im!ortant factors that influence exchange rates are discussed &elo-: Strength of the Economy :,he strength of the econom+ affects the demand and su!!l+ of foreign currenc+. .f an econom+ is gro-ing fast and is strong it -ill attract foreign currenc+ there&+ strengthening its o-n. $n the other hand/ -eaknesses result in an outflo- of foreign exchange. .f a countr+ is a net ex!orter 6as -ere 5a!an and Derman+7/ the inflo- of foreign currenc+ far outstri!s the outflo- of their o-n currenc+. ,he result is usuall+ a strengthening in its 'alue. Political and Psychological Factors: Aolitical or !s+chological factors are &elie'ed to ha'e an influence on exchange rates. >an+ currencies ha'e a tradition of &eha'ing in a !articular -a+ such as 1-iss francs -hich are kno-n as a refuge or safe ha'en currenc+ -hile the dollar mo'es 6either u! or do-n7 -hene'er there is a !olitical crisis an+-here in the -orld. Exchange rates can also fluctuate if there is a change in go'ernment. 1ome time &ack/ .ndiaCs foreign exchange rating -as do-ngraded &ecause of !olitical insta&ilit+ and conse4uentl+/ the external 'alue of the ru!ee fell. 8ars and other external factors also affect the exchange rate. For exam!le/ -hen *ill #

@linton -as im!eached/ the ;1 dollar -eakened. During the .ndo2Aak -ar the ru!ee -eakened. After the 1""" cou! in Aakistan 6$cto&er(Eo'em&er 1"""7/ the Aakistani ru!ee -eakened. Economic Expectations :Exchange rates mo'e on economic ex!ectations. After the 1""" &udget in .ndia there -as an ex!ectation that the ru!ee -ould fall &+ %? to "?. 1ince such ex!ectations affect the external 'alue of the ru!ee/ all economic data 2 the &alance of !a+ments/ ex!ort gro-th/ inflation rates and the likes 2 are anal+sed and its likel+ effect on exchange rates is examined. .f the economic do-nturn is not as &ad as antici!ated the rate can e'en a!!reciate. ,he mo'ement reall+ de!ends on the Fmarket sentimentG 2 the mood of the market 2 and homuch the market has reacted or discounted the antici!ated(ex!ected information. Inflation Rates : .t is -idel+ held that exchange rates mo'e in the direction re4uired to com!ensate for relati'e inflation rates. For instance/ if a currenc+ is alread+ o'er'alued/ i.e. stronger than -hat is -arranted &+ relati'e inflation rates/ de!reciation sufficient enough to correct that !osition can &e ex!ected and 'ice 'ersa. .t is necessar+ to note that an exchange rate is a relati'e !rice and hence the market -eighs all the relati'e factors in relati'e terms 6in relation to the counter!art countries7. ,he underl+ing reasoning &ehind this con'iction is that a relati'el+ high rate of inflation reduces a countr+Cs com!etiti'eness and -eakens its a&ilit+ to sell in international markets. ,his situation/ in turn/ -ill -eaken the domestic currenc+ &+ reducing the demand or ex!ected demand for it and increasing the demand or ex!ected demand for the foreign currenc+ 6increase in the su!!l+ of domestic currenc+ and decrease in the su!!l+ of foreign currenc+7. Capital Movements : @a!ital mo'ements are one of the most im!ortant reasons for changes in exchange rates. @a!ital mo'ements of foreign currenc+ are usuall+ more than connected -ith international trade. ,his occurs due to a 'ariet+ of reasons 2 &oth !ositi'e and negati'e. 8hen .ndia &egan its economic li&eralisation and in'ited Foreign .nstitutional .n'estors 6F..s7 to !urchase e4uit+ shares in .ndian com!anies/ &illions of ;1 dollars came into the countr+ strengthening the currenc+. .n 1""# and 1""%/ F..s took se'eral &illion ;1 dollars out of the countr+ -eakening the currenc+. ,hese -ere ca!ital outflo-s. $ne of the reasons !o!ularl+ &elie'ed for the ru!ee not de!reciating in the manner other 1outh2east Asian currencies did in 1""%2") -as &ecause the ru!ee -as not con'erti&le on the Fca!ital accountG. %

 Speculation : 1!eculation in a currenc+ raises or lo-ers the exchange rate. For instance/ the foreign exchange market in Hen+a is 'er+ shallo-. .f a s!eculator enters and &u+s ;1 I1 million/ it -ill raise the 'alue of the ;1 dollar significantl+. .f a fe- others do so too/ the !rice of the ;1 dollar -ill rise e'en further against the Hen+a shilling. ,he most famous s!eculator in foreign currenc+ is >r Deorge 1oros -ho made o'er a &illion !ounds sterling in Euro!e 6&+ correctl+ !redicting the de'aluation of the !ound7 and then is &elie'ed to ha'e triggered the free fall of the currencies of 1outh2east Asia. . Balance of Payments : As mentioned earlier/ a net inflo- of foreign currenc+ tends to strengthen the home currenc+ 'is2J2'is other currencies. ,his is &ecause the su!!l+ of the foreign currenc+ -ill &e in excess of demand. A good -a+ of ascertaining this -ould &e to check the &alance of !a+ments. .f the &alance of !a+ments is !ositi'e and foreign exchange reser'es are increasing/ the home currenc+ -ill &ecome stronger. overnment!s Monetary and Fiscal Policies : Do'ernments/ through their monetar+ and fiscal !olicies affect international trade/ the trade &alance and the su!!l+ and demand for a currenc+. .ncreasing the su!!l+ of mone+ raises !rices and makes im!orts attracti'e. Fiscal sur!luses -ill slo- economic gro-th and this -ill reduce demand for im!orts and encourage ex!orts. ,he effecti'eness of the !olic+ de!ends on the !rice and income elasticities of demand for the !articular goods. Bigh !rice elasticit+ of demand means the 'olume of a good is sensiti'e to a change in !rice. >onetar+ and fiscal !olic+ su!!ort the currenc+ through a reduction in inflation. ,hese also affect exchange rate through the ca!ital account. Eet ca!ital inflo-s su!!l+ direct su!!ort for the exchange rate. @entral go'ernments control monetar+ su!!l+ and the+ are ex!ected to ensure that the go'ernmentCs monetar+ !olic+ is follo-ed. ,o this extent the+ could increase or decrease mone+ su!!l+. For exam!le/ the Reser'e *ank of .ndia/ to cur& inflation/ restricted and cut mone+ su!!l+. .n Hen+a/ the central &ank in order to attract foreign mone+ into the countr+ is offering 'er+ high rates on its treasur+ &ills. .n order to maintain exchange rates at a certain !rice the central &ank -ill also inter'ene either &+ &u+ing foreign currenc+ 6-hen there is an excess in the su!!l+ of foreign exchange7 and selling foreign currenc+ 6-hen demand for foreign exchange exceeds su!!l+7. ,his is kno-n as Kcentral &ank inter'entionC. .t must &e noted that the o&:ecti'e of monetar+ !olic+ is to maintain sta&ilit+ and economic gro-th and central

&anks are ex!ected to 2 &+ increasing(decreasing mone+ su!!l+/ raising(lo-ering interest rates or &+ o!en market o!erations 2 maintain sta&ilit+. Exchange Rate Policy and Intervention: Exchange rates are also influenced/ in no small measure/ &+ ex!ectation of change in regulations relating to exchange markets and official inter'ention. $fficial inter'ention can smoothen an other-ise disorderl+ market. As ex!lained &efore/ inter'ention is the &u+ing or selling of foreign currenc+ to increase or decrease its su!!l+. @entral &anks often inter'ene to maintain sta&ilit+. .t has also &een ex!erienced that if the authorities attem!t to half2heartedl+ counter the market sentiments through inter'ention in the market/ ultimatel+ more stee! and sudden exchange rate s-ings can occur. Interest Rates : An im!ortant factor for mo'ement in exchange rates in recent +ears is interest rates/ i.e. interest differential &et-een ma:or currencies. .n this res!ect the gro-ing integration of financial markets of ma:or countries/ the re'olution in telecommunication facilities/ the gro-th of s!ecialised asset managing agencies/ the deregulation of financial markets &+ ma:or countries/ the emergence of foreign trading as !rofit centres !er se and the tremendous sco!e for &and-agon and s4uaring effects on the rates/ etc. ha'e accelerated the !otential for exchange rate 'olatilit+. Hen+a intrinsicall+ has a 'er+ -eak econom+ &ut the rates offered -ithin the countr+ ha'e al-a+s &een 'er+ high. ,o illustrate this !oint the treasur+ &ill rate in 1e!tem&er 1"") -as as high as 23?. Bigh interest rates attract s!eculati'e ca!ital mo'es so the announcements made &+ the Federal Reser'e on interest rates are usuall+ eagerl+ a-aited 2 an increase in the same -ill cause an inflo- of foreign currenc+ and the strengthening of the ;1 dollar. "ariffs and #uotas : ,ariffs and 4uotas exist to !rotect a countr+Cs foreign exchange &+ reducing demand. ,ill &efore li&eralisation/ .ndia follo-ed a !olic+ of tariffs and restrictions on im!orts. Ler+ fe- items -ere !ermitted to &e freel+ im!orted. Additionall+/ high customs duties -ere im!osed to discourage im!orts and to !rotect the domestic industr+. ,ariffs and 4uotas are not !o!ular internationall+ as the+ tend to close markets. 8hen .ndia lifted its &arriers/ se'eral industries such as the mini steel and the scra! metal industries colla!sed 6im!orted scra! &ecame chea!er than the domestic one7. Muotas are not restricted to de'elo!ing countries. ,he ;nited "

1tates im!oses 4uotas on read+made garments and 5a!an has se'ere 4uotas on non25a!anese goods. Exchange Control : ,he !ur!ose of exchange control is to manage the su!!l+ and demand &alance of the home currenc+ &+ the go'ernment using direct controls &asicall+ to !rotect it. @urrenc+ control is the restriction of using or a'ailing of foreign currenc+ at home(a&road. .n .ndia/ u! to li&erali9ation in the nineties there -as 'er+ se'ere exchange control. Access to foreign currenc+ -as tightl+ controlled and the same -as released onl+ for !ermitted !ur!oses. ,his -as &ecause .ndian ex!orts had not taken off and there -ere still large im!orts. ,here are se'eral countries that maintain their rates at artificial le'els such as *angladesh. .ndia is no- full+/ con'erti&le on the current account &ut not as +et on the ca!ital account. ,his/ to an extent/ !ossi&l+ sa'ed .ndia -hen the run on currencies took !lace in Asia in 1""%. .f the .ndian ru!ee -as full+ con'erti&le and there -ere no exchange control restrictions/ the ru!ee -ould ha'e &een o!en for s!eculation. ,here -ould ha'e &een large outflo-s at a time of concern resulting in a sno-&alling !lunge in its 'alue. As long as the !ar 'alue s+stem !re'ailed/ the rates could not go &e+ond the u!!er and lo-er inter'ention !oints. ,he onl+ real 4uestion under the fixed rate s+stem -as -hether the &alance of !a+ments and foreign exchange reser'es had deteriorated to such an extent that de'aluation -as imminent or !ossi&le. @ountries -ith strong &alance of !a+ments and reser'e !ositions -ere hardl+ called u!on to re'alue their currencies. Bence/ a -atch had to &e ke!t onl+ on deficit countries. Bo-e'er/ under generali9ed floating regime/ exchange rates are influenced &+ a multitude of economic/ financial/ !olitical and !s+chological factors. *ut the relati'e significance of an+ of these factors can 'ar+ from time to time making it difficult to !redict !recisel+ ho- an+ single factor -ill influence the rates and &+ ho- much.

%etermination of Exchange &ates

.n sim!le terms/ it is the interaction of su!!l+ and demand factors for t-o currencies in the market that determines the rate at -hich the+ trade. *ut -hat factors influence the man+ thousands of decisions made each da+ to &u+ or sell a currenc+3 Bo- do changes in su!!l+ and demand conditions ex!lain the !ath of an exchange rate o'er the course of a da+/ a month/ or a +ear3 ,his com!lex issue has &een extensi'el+ studied in economic literature and -idel+ discussed among in'estors/ officials/ academicians/ traders/ and others. 1till/ there are no definiti'e ans-ers. Lie-s on exchange rate determination differ and ha'e changed o'er time. Eo single a!!roach !ro'ides a satisfactor+ ex!lanation of exchange rate mo'ements/ !articularl+ short2 and medium2term mo'ements/ since the ad'ent of -ides!read floating in the earl+ 1"% s. ,hree as!ects of exchange rate determination are discussed &elo-. First/ there is a &rief descri!tion of some of the &road a!!roaches to exchange rate determination. 1econd/ there are some comments on the !ro&lems of exchange rate forecasting in !ractice. ,hird/ central &ank inter'ention and its effects on exchange rates are discussed. 1ome a!!roaches to exchange rate determination: "he Purchasing Po$er Parity %pproach Aurchasing Ao-er Aarit+ 6AAA7 theor+ holds that in the long run/ exchange rates -ill ad:ust to e4uali9e the relati'e !urchasing !o-er of currencies. ,his conce!t follo-s from the la- of one !rice/ -hich holds that in com!etiti'e markets/ identical goods -ill sell for identical !rices -hen 'alued in the same currenc+. ,he la- of one !rice relates to an indi'idual !roduct. A generali9ation of that la- is the a&solute 'ersion of AAA/ the !ro!osition that exchange rates -ill e4uate nationsC o'erall !rice le'els. >ore commonl+ used than a&solute AAA is the conce!t of relati'e AAA/ -hich focuses on 11

changes in !rices and exchange rates/ rather than on a&solute !rice le'els. Relati'e AAA holds that there -ill &e a change in exchange rates !ro!ortional to the change in the ratio of the t-o nationsC !rice le'els/ assuming no changes in structural relationshi!s. ,hus/ if the ;.1. !rice le'el rose 1 !ercent and the 5a!anese !rice le'el rose 5 !ercent/ the ;.1. dollar -ould de!reciate 5 !ercent/ offsetting the higher ;.1. inflation and lea'ing the relati'e !urchasing !o-er of the t-o currencies unchanged. AAA is &ased in !art on some unrealistic assum!tions: that goods are identicalN that all goods are trada&leN that there are no trans!ortation costs/ information ga!s/ taxes/ tariffs/ or restrictions of tradeN and Oim!licitl+ and im!ortantl+Othat exchange rates are influenced onl+ &+ relati'e inflation rates. *ut contrar+ to the im!licit AAA assum!tion/ exchange rates also can change for reasons other than differences in inflation rates. Real exchange rates can and do change significantl+ o'er time/ &ecause of such things as ma:or shifts in !roducti'it+ gro-th/ ad'ances in technolog+/ shifts in factor su!!lies/ changes in market structure/ commodit+ shocks/ shortages/ and &ooms. .n addition/ the relati'e 'ersion of AAA suffers from measurement !ro&lems:8hat is a good starting !oint/ or &ase !eriod3 8hich is the a!!ro!riate !rice index3 Bo- should -e account for ne- !roducts/ or changes in tastes and technolog+3 AAA is intuiti'el+ !lausi&le and a matter of common sense/ and it undou&tedl+ has some 'alidit+ Osignificantl+ different rates of inflation should certainl+ affect exchange rates. AAA is useful in assessing long2term exchange rate trends and can !ro'ide 'alua&le information a&out long2run e4uili&rium. *ut it has not met -ith much success in !redicting exchange rate mo'ements o'er short2 and medium2term hori9ons for -idel+ traded currencies. .n the short term/ AAA seems to a!!l+ &est to situations -here a countr+ is ex!eriencing 'er+ high/ or e'en h+!erinflation/ in -hich large and continuous !rice rises o'er-helm other factors. "he Balance of Payments and the Internal& External Balance %pproach

12

AAA concentrates on one !art of the &alance of !a+mentsOtrada&le goods and ser'icesO and !ostulates that exchange rate changes are determined &+ international differences in !rices/ or changes in !rices/ of trada&le items. $ther a!!roaches ha'e focused on the &alance of !a+ments on current account/ or on the &alance of !a+ments on current account !lus long2term ca!ital/ as a guide in the determination of the a!!ro!riate exchange rate. *ut in toda+Cs -orld/ it is generall+ agreed that it is essential to look at the entire &alance of !a+mentsO&oth current and ca!ital account transactionsOin assessing foreign exchange flo-s and their role in the determination of exchange rates. 5ohn 8illiamson and others ha'e de'elo!ed the conce!t of the Ffundamental e4uili&rium exchange rate/G or FEER/ en'isaged as the e4uili&rium exchange rate that -ould reconcile a nationCs internal and external &alance. .n that s+stem/ each countr+ -ould commit itself to a macroeconomic strateg+ designed to lead/ in the medium term/ to Finternal &alanceGOdefined as unem!lo+ment at the natural rate and minimal inflationOand to Fexternal &alanceGOdefined as achie'ing the targeted current account &alance. Each countr+ -ould &e committed to holding its exchange rate -ithin a &and or target 9one around the FEER/ or the le'el needed to reconcile internal and external &alance during the inter'ening ad:ustment !eriod. ,he conce!t of FEER/ as an e4uili&rium exchange rate to reconcile internal and external &alance/ is a useful one. *ut there are !ractical !ro&lems in calculating FEERs.,here is no uni4ue ans-er to -hat constitutes the FEERN de!ending on the !articular assum!tions/ models/ and econometric methods used/ different anal+sts could come to 4uite different results. ,he authors recogni9e this difficult+/ and ackno-ledge that some allo-ance should &e made &+ -a+ of a target &and around the FEER.8illiamson has suggested that FEER calculations could not realisticall+ :ustif+ exchange rate &ands narro-er than !lus or minus 1 !ercent.

13

,he .>F/ -hile generall+ agreeing that it is not !ossi&le to identif+ !recise Fe4uili&riumG'alues for exchange rates and that !oint estimates of notional e4uili&rium rates should generall+ &e a'oided/ does use a macroeconomic &alance methodolog+ to under!in its internal .>F multilateral sur'eillance. ,his mehodolog+/ -hich is used for assessing the Fa!!ro!riatenessGof current account !ositions and exchange rates for ma:or industrial countries/ is descri&ed in *ox 1121.% "he Monetary %pproach ,he monetar+ a!!roach to exchange rate determination is &ased on the !ro!osition that exchange rates are esta&lished through the !rocess of &alancing the total su!!l+ of/ and the total demand for/ the national mone+ in each nation. ,he !remise is that the su!!l+ of mone+ can &e controlled &+ the nationCs monetar+ authorities/ and that the demand for mone+ has a sta&le and !redicta&le linkage to a fe- ke+ 'aria&les/ including an in'erse relationshi! to the interest rateOthat is/ the higher the interest rate/ the smaller the demand for mone+. .n its sim!lest form/ the monetar+ a!!roach assumes that: !rices and -ages are com!letel+ flexi&le in &oth the short and long run/ so that AAA holds continuousl+/ that ca!ital is full+ mo&ile across national &orders/ and that domestic and foreign assets are !erfect su&stitutes. 1tarting from e4uili&rium in the mone+ and 14

foreign exchange markets/ if the ;.1. mone+ su!!l+ increased/ sa+/ 2 the dollar -ould de!reciate 2 !ercent in terms of the +en.

!ercent/ -hile the

5a!anese mone+ su!!l+ remained sta&le/ the ;.1. !rice le'el/ in time/ -ould rise 2 !ercent and

.n this sim!lified 'ersion/ the monetar+ a!!roach com&ines the AAA theor+ -ith the 4uantit+ theor+ of mone+Oincreases or decreases in the mone+ su!!l+ lead to !ro!ortionate increases or decreases in the !rice le'el o'er time/ -ithout an+ !ermanent effects on out!ut or interest rates. >ore so!histicated 'ersions relax some of the restricti'e assum!tionsOfor exam!le/ !rice flexi&ilit+ and AAA ma+ &e assumed not to hold in the short runO&ut maintain the focus on the role of national monetar+ !olicies. Em!irical tests of the monetar+ a!!roachO sim!le or so!histicatedOha'e failed to !ro'ide an ade4uate ex!lanation of exchange rate mo'ements during the floating rate !eriod. ,he a!!roach offers onl+ a !artial 'ie- of the forces influencing exchange ratesOit assumes a-a+ the role of nonmonetar+ assets such as &onds/ and it takes no ex!licit account of su!!l+ and demand conditions in goods and ser'ices markets. Des!ite its limitations/ the monetar+ a!!roach offers 'er+ useful insights. .t highlights the im!ortance of monetar+ !olic+ in influencing exchange rates/ and correctl+ -arns that excessi'e monetar+ ex!ansion leads to currenc+ de!reciation. ,he monetar+ a!!roach also !ro'ides a &asis for ex!laining exchange rate o'ershootingOa situation often o&ser'ed in exchange markets in -hich a !olic+ mo'e can lead to an initial exchange rate mo'e that exceeds the e'entual change im!lied &+ the ne- long2term situation. .n the context of monetar+ a!!roach models that incor!orate short2term stickiness in !rices/ exchange rate o'ershooting can occur &ecause !rices of financial assetsOinterest and exchange ratesOres!ond more 4uickl+ to !olic+ mo'es than does the !rice le'el of goods and ser'ices. ,hus/ for exam!le/ a mone+ su!!l+ increase 6or decrease7 in the ;nited 1tates can lead to a greater tem!orar+ dollar de!reciation 6a!!reciation7 as domestic interest rates decline 6rise7 tem!oraril+ &efore the ad:ustment of the !rice le'el to the ne- long2run e4uili&rium is com!leted and interest rates return to their original le'els.

15

"he Portfolio Balance %pproach

,he !ortfolio &alance a!!roach takes a shorter2term 'ie- of exchange rates and &roadens the focus from the demand and su!!l+ conditions for mone+ to take account of the demand and su!!l+ conditions for other financial assets as -ell. ;nlike the monetar+ a!!roach/ the !ortfolio &alance a!!roach assumes that domestic and foreign &onds are not !erfect su&stitutes. According to the !ortfolio &alance theor+ in its sim!lest form/ firms and indi'iduals &alance their !ortfolios among domestic mone+/ domestic &onds/ and foreign currenc+ &onds/ and the+ modif+ their !ortfolios as conditions change. .t is the !rocess of e4uili&rating the total demand for/ and su!!l+ of/ financial assets in each countr+ that determines the exchange rate. Each indi'idual and firm chooses a !ortfolio to suit its needs/ &ased on a 'ariet+ of considerationsOthe holderCs -ealth and tastes/ the le'el of domestic and foreign interest rates/ ex!ectations of future inflation/ interest rates/ and so on. An+ significant change in the underl+ing factors -ill cause the holder to ad:ust his !ortfolio and seek a ne- e4uili&rium. ,hese actions to &alance !ortfolios -ill influence exchange rates. Accordingl+/ a nation -ith a sudden increase in mone+ su!!l+ -ould immediatel+ !urchase &oth domestic and foreign &onds/ resulting in a decline in &oth countriesC interest rates/ and/ to the extent of the shift to foreign &onds/ a de!reciation in the nationCs home currenc+. $'er time/ the de!reciation in the home currenc+ -ould lead to gro-th in the nationCs ex!orts and a decline in its im!orts/ and thus/ to an im!ro'ed trade &alance and re'ersal of !art of the original de!reciation. As +et/ there is no unified theor+ of exchange rate determination &ased on the !ortfolio &alance a!!roach that has !ro'ed relia&le in forecasting. .n fact/ results of em!irical tests of the !ortfolio &alance a!!roach do not com!are fa'ora&l+ -ith those from sim!ler models. ,hese results reflect &oth conce!tual !ro&lems and the lack of ade4uate data on the si9e and currenc+

1#

com!osition of !ri'ate sector !ortfolios.

1%

1)

Ee'ertheless/ the !ortfolio &alance a!!roach offers a useful frame-ork for stud+ing exchange rate determination. 8ith its focus on a &road menu of assets/ this a!!roach !ro'ides richer insights than the monetar+ a!!roach into the forces influencing exchange rates. .t also ena&les foreign exchange rates to &e seen like asset !rices in other markets/ such as the stock market or &ond market/ -here rates are influenced/ not onl+ &+ current conditions/ &ut to a great extent &+ market ex!ectations of future e'ents. As -ith other financial assets/ exchange rates change continuousl+ as the market recei'es ne- information a&out current conditions and information that affects ex!ectations of the future. ,he random character of these asset !rice mo'ements does not rule out rational !ricing. .ndeed/ it is !ersuasi'el+ argued that this is the result to &e ex!ected in a -ell functioning financial market. *ut in such an en'ironment/ exchange rate changes can &e large and 'er+ difficult to !redict/ as market !artici!ants tr+ to :udge the ex!ected real rates of return on their domestic assets in com!arison -ith alternati'es in other currencies. 'o$ (ood Are the )arious Approaches? ,he a!!roaches noted a&o'e are some of the most general and most familiar ones/ &ut there are man+ others/ focusing on differentials in real interest rates/ on fiscal !olicies/ and on other elements.

1"

,he research on this to!ic has &een of great 'alue in enhancing our understanding of long2run exchange rate trends and the issues in'ol'ed in estimating Fe4uili&riumG rates. .t has hel!ed us understand 'arious as!ects of exchange rate &eha'ior and !articular exchange rate e!isodes. Pet none of the a'aila&le em!irical models has !ro'ed ade4uate for making relia&le !redictions of the course of exchange rates o'er a !eriod of time. Research thus far has not &een a&le to find sta&le and significant relationshi!s &et-een exchange rates and an+ economic fundamentals ca!a&le of consistentl+ !redicting or ex!laining short2term rate mo'ements.

Foreign exchange forecasting in practice

>ost of the a!!roaches to exchange rate determination tell onl+ !art of the stor+Olike the se'eral &lindfolded men touching different !arts of the ele!hantCs &od+Oand other/ more com!rehensi'e ex!lanations cannot/ in !ractice/ &e used for !recise forecasting. 8e do not +et ha'e a -a+ of &ringing together all of the factors that hel! determine the exchange rate in a single com!rehensi'e a!!roach that -ill !ro'ide relia&le short2 to medium2term !redictions. ,he exchange rate is a !er'asi'e and com!lex mechanism/ influencing and &eing influenced &+ man+ different forces/ -ith the effects and the relati'e im!ortance of the different influences continuousl+ changing as conditions change. ,o the extent that trade flo-s are a force in the market/ com!etiti'eness is o&'iousl+ im!ortant to the exchange rate/ and the man+ factors affecting com!etiti'eness must &e considered.,o the extent that the mone+ market is a factor/ the focus should &e on short2term interest rates/ and on monetar+ !olic+ and other factors influencing those shortterm interest rates. ,o the extent that !ortfolio ca!ital flo-s matter/ the focus should &e &roadened to include &ond market conditions and long2term interest rates. Aarticularl+ at times of great international tension/ all other factors affecting the dollar exchange rate ma+ &e o'er-helmed &+ considerations of Fsafe ha'en.G .ndeed/ countless forces influence the exchange rate/ and the+ are su&:ect to continuous and un!redicta&le changes o'er time/ &+ a market that is &road and heterogenous in terms of the !artici!ants/ their interests/ and their time frames. 8ith conditions al-a+s changing/ the im!act of !articular e'ents and the res!onse to !articular !olic+ actions can 'ar+ greatl+ -ith the circumstances at the time. Bigher interest rates might strengthen a currenc+ or -eaken it/ &+ a small amount or &+ a lotOmuch de!ends on -h+ the interest rates -ent u!/ -hether a mo'e -as antici!ated/ -hat su&se4uent mo'es are ex!ected/ and the im!lications for other financial markets/ decisions/ or go'ernment !olic+ mo'es. 1imilarl+/ the results of exchange rate changes are not al-a+s !redicta&le: .m!orters might ex!ect to !a+ more if their domestic currenc+ de!reciates/ &ut not if foreign !roducers are 21

F!ricing to marketG in order to esta&lish a &eachhead or maintain a market share/ or if the im!orters or ex!orters had antici!ated the rate mo'e and had acted in ad'ance to !rotect themsel'es from it. Eonetheless/ those !artici!ating in the market must make their forecasts/ im!licitl+ and ex!licitl+/ da+ after da+/ all of the time. E'er+ !iece of information that &ecomes a'aila&le can &e the &asis for an ad:ustment of each !artici!antCs 'ie-!oint/ or ex!ectationsOin other -ords/ a forecast/ informal or other-ise. 8hen the screen flashes -ith an unex!ected announcement that/ sa+/ Derman+ has reduced interest rates &+ a 4uarter of one !ercent/ that is not :ust ne-s/ it is the &asis for countless assessments of the significance of that e'ent/ and countless forecasts of its im!act in num&er of &asis !oints. ,hose -ho forecast foreign exchange rates often are di'ided into those -ho use FtechnicalG anal+sis/ and those -ho rel+ on anal+sis of Ffundamentals/G such as DDA/ in'estment/ sa'ing/ !roducti'it+/ inflation/ &alance of !a+ments !osition/ and the like. ,echnical anal+sis assumes certain short2term and longer2term !atterns in exchange rate mo'ements. .t differs from the Frandom -alkG !hiloso!h+Othe &elief that all !resentl+ a'aila&le information has &een a&sor&ed into the !resent exchange rate and that/ the next !iece of information as -ell as the direction of the next rate mo'e is random/ -ith a 5 !ercent chance the rate -ill rise/ and 5 !ercent chance it -ill decline.

22

Eearl+ all traders ackno-ledge their use of technical anal+sis and charts. According to sur'e+s/ a ma:orit+ sa+ the+ em!lo+ technical anal+sis to a greater extent than FfundamentalG anal+sis/ and

23

that the+ regard it as more useful than fundamental anal+sisOa contrast to t-ent+ +ears ago -hen most said the+ relied man+ more hea'il+ on fundamental anal+sis. Aerha!s traders use technical anal+sis in !art &ecause/ at least su!erficiall+/ it seems sim!ler/ or &ecause the data are more current and timel+. Aerha!s the+ use it &ecause traders often ha'e a 'er+ short2term time frame and are interested in 'er+ short2term mo'es. ,he+ might agree that FfundamentalsG determine the course of !rices in the long run/ &ut the+ ma+ not regard that as rele'ant to their immediate task/ !articularl+ since man+ FfundamentalG data &ecome a'aila&le onl+ -ith long lags and are often su&:ect to ma:or re'isions. Aerha!s traders think technical anal+sis -ill &e effecti'e in !art &ecause the+ kno- man+ other market !artici!ants are rel+ing on it. 1till/ s!otting trends is of real im!ortance to tradersOFa trend is a friendG is a comment often heardOand technical anal+sis can add some disci!line and so!histication to the !rocess of disco'ering and follo-ing a trend. ,echnical anal+sis ma+ add more o&:ecti'it+ to making the difficult decision on -hen to gi'e u! on a !ositionOena&ling one to see that a trend has changed or run its course/ and it is no- time for reconsideration. >ost market !artici!ants !ro&a&l+ use a com&ination of &oth fundamental and technical anal+sis/ -ith the em!hasis on each shifting as conditions changeOthat is/ the+ form a general 'ie- a&out -hether a !articular currenc+ is o'er'alued or under'alued in a structural or longer2term sense/ and -ithin that longer2term frame-ork/ assess the order flo- and all current economic forecasts/ ne-s e'ents/ !olitical de'elo!ments/ statistical releases/ rumors/ and changes in sentiment/ -hile also carefull+ stud+ing the charts and technical anal+sis.

24

*fficia actions to inf uence exchange rates

As in some other ma:or industrial nations -ith floating exchange rate regimes/in the ;nited 1tates there is considera&le sco!e for the !la+ of market forces in determining the dollar exchange rate.*ut also/ as in other countries/;.1. authorities do take ste!s at times to influence the exchange rate/ 'ia !olic+ measures and direct inter'ention in the foreign exchange market to &u+ or sell foreign currencies.As noted a&o'e/ in !ractice/ all foreign exchange market inter'ention of the ;.1. authorities is routinel+ sterili9edOthat is/ the initial effect on ;.1. &ank reser'es is offset &+ monetar+ !olic+ action. Eo one 4uestions that monetar+ !olic+ measures can influence the exchange rate &+ affecting the relati'e attracti'eness of a currenc+ and ex!ectations of its !ros!ects/ although it is difficult to find a sta&le and significant relationshi! that -ould +ield a !redicta&le/ !recise res!onse. *ut the 4uestion of the effecti'eness of sterili9ed inter'ention/ -hich has &een extensi'el+ studied and de&ated/ is much more contro'ersial. 1ome economists contend that sterili9ed inter'ention can ha'e/ at &est/ a modest and tem!orar+ effect. $thers sa+ it can ha'e a more significant effect &+ changing ex!ectations a&out !olic+ and hel!ing to guide the market. 1till others &elie'e that the effect de!ends on the !articular market conditions and the inter'ention strateg+ of each situation. Di'en the !resent si9e of ;.1. monetar+ aggregates/ &alance of !a+ments flo-s/ and the le'els of acti'it+ in the foreign exchange market and other financial markets/ it is -idel+ acce!ted that an+ effects of sterili9ed inter'ention are likel+ to &e through indirect channels rather than through direct im!act on these large aggregates. Em!irical tests of sterili9ed inter'ention ha'e focused on t-o main channels through -hich such inter'ention might indirectl+ influence the exchange rate: the !ortfolio &alance channel and the ex!ectations/ or signaling/ channel.. ,he !ortfolio &alance channel !ostulates that the exchange rate is determined &+ the &alance of su!!l+ and demand for a'aila&le stocks of financial assets held &+ the !ri'ate sector. .t holds that sterili9ed inter'ention -ill alter the currenc+ com!osition of assets a'aila&le to the glo&al !ri'ate sector/ and that if dollar and foreign currenc+2denominated assets are 'ie-ed &+ in'estors as im!erfect su&stitutes/ sterili9ed inter'ention -ill cause mo'ements in the exchange rate to ree4uili&rate su!!l+ and demand for dollar assets. ,he si9e of this !ortfolio &alance effect -ould 25

de!end on the degree of su&stituta&ilit+ &et-een assets denominated in different currencies and on the si9e of the inter'ention o!eration. ,he ex!ectations/ or signaling/ channel holds that sterili9ed inter'ention ma+ cause !ri'ate agents to change their ex!ectations of the future !ath of the exchange rate. ,hus/ inter'ention could signal information a&out the future course of monetar+ or other economic !olicies/ signal information a&out/ or anal+sis of/ economic fundamentals or market trends/ or influence ex!ectations &+ affecting technical conditions such as &u&&les and &and-agons. A considera&le num&er of studies ha'e found no 4uantitati'el+ im!ortant effects of sterili9ed inter'ention through the !ortfolio &alance channel. 1ome studies ha'e found ex!ectations or signaling effects of 'ar+ing degrees of significance. $thers conclude that the effecti'eness de!ends 'er+ much on market conditions and inter'ention strateg+. ,here are serious data and econometric !ro&lems in stud+ing this 4uestion. ,o assess success/ the researcher needs to kno- the o&:ecti'e of the inter'ention and other s!ecific detailsO-as the aim to ameliorate a trend/ sto! a trend/ re'erse a trend/ sho- a !resence/ calm a market/ discourage s!eculation/ or &u+ a little time3 ,he researcher also needs to kno- the counterfactual O-hat -ould ha'e ha!!ened if the inter'ention had not taken !lace. Also/ research on this issue must &e !laced in the &roader context of research on exchange rate determination/ -hich noted a&o'e/ indicates that it has not &een !ossi&le to find sta&le and significant relationshi!s &et-een exchange rates and an+ economic fundamentals. As a !ractical matter/ it is difficult to make s-ee!ing assessments a&out the success or failure of official inter'ention o!erations. 1ome inter'ention o!erations ha'e !ro'en resoundingl+ successful/ -hile others ha'e &een dismal failures. ,he success or failure of inter'ention is not so much a matter of statistical !ro&a&ilit+ as it is a matter of ho- it is used and -hether conditions are a!!ro!riate. .s the o&:ecti'e reasona&le3 Does the market look technicall+ res!onsi'e3 .s inter'ention antici!ated3 8ill an o!eration look credi&le3 8hat is the likel+ effect on ex!ectations3

2#

.n 1")3/ the 8orking Drou! on Foreign Exchange >arket .nter'ention esta&lished at the Lersailles summit of the Drou! of 1e'en -arned against ex!ecting too much from official inter'ention/ &ut concluded that such inter'ention can &e a useful and effecti'e tool in influencing exchange rates in the short run/ es!eciall+ -hen such o!erations are consistent -ith fundamental economic !olicies. ;n4uestiona&l+/ inter'ention o!erations are more likel+ to succeed -hen there is a consistenc+ -ith fundamental economic !olicies/ &ut it ma+ not al-a+s &e !ossi&le to kno- -hether that consistenc+ exists. Although attitudes differ/ monetar+ authorities in all of the ma:or countries inter'ene in the foreign exchange markets at times -hen the+ consider it useful or a!!ro!riate/ and the+ are likel+ to continue to do so. ,he current attitude to-ard foreign exchange market inter'ention is summari9ed in the follo-ing excer!t from the 5une 1""# re!ort of the finance ministers of the Drou! of 1e'en nations:

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F exi" e +,s fixed exchange rates

Exchange rates sta&ilit+ has al-a+s &een the o&:ecti'e of monetar+ !olic+ of almost all countries. Exce!t during the !eriod of great de!ression and -orld -ar.. / the exchange rate ha'e &een almost sta&le.during the !ost2 -ar .. !eriod / the .>F had &rought a ne- !hase of exchange rate sta&ilit+. >ost go'ernments ha'e maintained ad:usta&le fixed exchange rates till 1"%3. *ut the .>F s+stem failed to !ro'ide an ade4uate solution to three ma:or !ro&lems causing exchange insta&ilit+2 1. Aro'iding sufficient reser'es to mitigate the short term fluctuations in the &alance of !a+ments -hile maintaining the fixed exchange arte s+stem. 2. Aro&lems of long term ad:ustments in the &alance of !a+ments. 3. Arices generated &+ s!eculati'e transactions. For these reasons the currencies of man+ countries / es!eciall+ the reser'e currenc+ -ere su&:ect to fre4uent de'aluation in the earl+ 1"% /s. this raised dou&ts a&out the !ossi&ilit+ of the *retten-ood/s s+stem/and also a&out the 'ia&ilit+ of the fixed exchange rate s+stem. ,he &reakdo-n of *retton-ood s+stem generated a de&ate on -hether fixed or flexi&le exchange rate should &e used.Q ,he main arguments in fa'our of fixed exchange rates are2 Firstly/Fixed exchange rate !ro'ides sta&ilit+ in the foreign exchange market and certaint+ a&out the future course of the exchange rate and it eliminates risks caused &+ uncertaint+ due to fluctuations in the exchange rates. ,he sta&ilit+ of exchange rate encourages international trade.on the contrar+/ flexi&le exchange rate s+stem causes uncertaint+ and might also often lead to 'iolent fluctuations in international trade. As a result foreign trade oriented economies &ecome su&:ect to se'ere economic fluctuations/ if im!ort elasticities are less than ex!ort elasticities. Secondly / the fixed exchange rate s+stem creates conditions for smooth flo- of international ca!ital sim!l+ &ecause it ensures a certain return on the foreign in'estment. 8hile in the case of 2)

flexi&le exchange rate/ ca!ital flo-s are constrained &ecause of uncertainit+ a&out ex!ected rate of return. Thirdly, the fixed rate eliminates the !ossi&ilit+ of s!eculation/ -here&+ it remo'es the dangers of s!eculati'e acti'ities in the foreign exchange market. $n the contrar+ flexi&le exchange rates encourage s!eculation. Fourthly , the fixed exchange rate s+stem reduces the !ossi&ilit+ of com!etiti'e de!reciation of currencies as it ha!!ened during 1"3 s. also/ de'iations from fixed rate are easil+ ad:usta&le. Fifthly/ a case is also made in fa'our of fixed exchange rate on the &asis of existence of currenc+ areas. ,he flexi&le exchange rate is said to &e unsuita&le &et-een the nations -hich constitute a currenc+ area/ since it leads to a chaotic situation and hence ham!ers trade &et-een them. ,he main arguments in fa'our of flexi&le exchange rates : Firstly, flexi&le exchange rate s+stem !ro'ides larger degree of autonom+ in res!ect of domestic economic !olicies as it is not o&ligator+ for the coutries to tune their domestic !olicies to fixed foreign exchange rate. Secondly/ flexi&le exchange rate is self ad:usting and therefore it does not de'ol'e on the go'ernment to maintain an ade4uate foreign exchange reser'e. Thirdly, the flexi&le exchange rate/ -hich is determined &+ market forces/ has a theor+ &ehind it and has the 4ualit+ of !redicta&ilit+. Fourthly/ flexi&le exchange rates ser'e as a &arometer of the actual !urchasing !o-er and strength of a currenc+ in the foreign exchange market. .t ser'es as a useful !arameter in the formulation of the domestic economic !olicies.

2"

Fifthly, economists ha'e also argued that the most serious charge against fluctuating exchange rate i.e. unceratint+ is not tena&le &ecause s!eculators themsel'es create conditions for exchange rate sta&ilit+. Also/ the degree of uncertainit+ associated -ith flexi&le exchange rate could not &e much greater then -hat the -orld has ex!erienced -ith ad:usta&le fixed exchange rate under the &retton-oodCs s+stem. ,he de&ate on fixed '(s flexi&le exchange rate is inconclusi'e . infact/ &oth s+stems ha'e their o-n merits and demerits.

-i" iograph#
*ooks 2 >anagerial Economics &+ D.E. D-i'edi. >anagerial Economics &+ @hatur'edi. >acroeconomics &+ R.H.>isra >acroeconomics &+ >.<. 1eth 1ites = ---.forex.com ---.mone+in'estment.com

1. 2. 3. 4.

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