REFORM Project, USAID/India

Workshop on Macroeconomic
Aspects

Exchange Rate Policy

Khwaja M. Sultan

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 Exchange rate

 Nominal exchange rate – the rate at which we can trade the

currency of one country for the currency of another
 Real exchange rate – the rate at which we can trade the goods
and services of one country with the goods and services of another
 Measures the price of a basket of goods and services available
domestically relative to the same basket available abroad –
purchasing power parity
Real exchange rate = Nominal exchange rate x Domestic price
Foreign price
{The prices are measured in the respective local currency}
 Real exchange rate = (e x P ) / P*
 e= nominal exchange rate; P = domestic price index; P* = price
index abroad
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 Shows that nominal exchange rate reflects relative inflation
 Balance of Payment and Exchange Rate

 Balance of Payment – the record of all transactions of the

residents with the rest of the world
 Trade balance – Balance of exports and imports of goods –
exports are positive and imports are negative
 Current account balance – Balance of trade in goods, (trade
balance), trade in services and transfer payments
 Balance in services includes freight, royalty payments, interest
payments, dividend from assets abroad
 Transfer payments include remittances, gifts and grants
 Capital account balance – purchase and sale of assets –
stocks, bonds, land – purchase by Indians of assets abroad is
negative, purchase of assets by foreigners in India (e.g., FDI) are
positive
 Current account + Capital account = 0
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 Increase in official reserves is called overall BOP surplus
 Terms
 Devaluation – the price of foreign currencies under a
fixed exchange rate regime is increased by official
action
 Revaluation - the price of foreign currencies under a
fixed exchange rate regime is decreased by official
action

 Depreciation – under a floating rate system, price of

foreign currencies decreases because of market
adjustment
 Appreciation - under a floating rate system, price of
foreign currencies decreases because of market
adjustment
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 Fixed Exchange Rate

 In a fixed exchange rate system – foreign central banks buy

and sell their currencies at a fixed price in terms of the domestic
currency
 Prior to 1973, most countries had fixed exchange rates against each
other
 A fixed exchange rate acts like a price support system
 In order to maintain a fixed exchange rate, the central bank has to
make up for the excess demand or take up the the excess supply of
foreign currency.
 In order to carry out these interventions, it is necessary for the
central bank to hold an inventory of foreign currencies.
 However, if the country persistently runs deficits in the BOP, the
central bank eventually runs out of foreign currencies, and will not
be able to carry out the interventions
 In such a situation, the central bank will have to ultimately devalue 5
its currency
 Fixed Exchange Rate

E E
Exchange rate
E
E

E2

E1

6
Quantity of dollars
 Pros and Cons of Fixed Exchange Rate
 Argument in favor of fixed exchange rate
 Certainty
Less inflationary
Promotes money and capital markets
Helps in the smooth working of the international monetary
system
Prevents monetary shocks
 Argument against fixed exchange rate
 Heavy burden on exchange reserve
Country must have sufficient reserve
Fails to solve the balance of payment disequilibrium
Does not prevent real shock
It is not a long term solution if the underlying economy is
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weak
 Flexible Exchange Rate
 In a flexible exchange rate system, the central bank allows
the exchange rate to adjust to equate the supply and demand
for foreign currency. In effect since 1973
 Clean floating – the central bank stands aside completely and
allows the exchange rate to be freely determined in the forex
market – official reserve transactions are zero
 Managed float - the central bank intervenes to buy or sell
foreign currencies periodically in an attempt to influence the
exchange rates
 Snake in the lake
 Snake in the tube
 Crawling peg
 Target zones
 Currency board 8
 Flexible Exchange Rate
Exchange rate

$2
E2

E1 $1 $”

E $’
$
D2

D1
D

Quantity of dollars 9
 History of Flexible Exchange Rate
• Collapse of the Bretton Woods system in 1971 when the
US Treasury refused to convert short-term liabilities into
gold and made dollar inconvertible
• 48 countries including the US, Japan, many EU countries
abandoned the fixed exchange rate
• Group of Ten industrialized countries met at the
Smithsonian Institute in Washington, DC in December
1971; agreed to a new system of stable exchange rate
with wider bands – US devalued 8%, Japan revalued
17%, Germany revalued 14% - allowed 2.25 %
fluctuation plus/minus;1973 fluctuation widened to 4.5%
• US devalued again in Feb 1973 – Smithsonian
Agreement collapsed 10
• ECU 1979, euro 2001
Pros and Cons of Flexible Exchange Rate
 Argument in favor of flexible exchange rate
 Simple operation, smoother, more fluid adjustment
 Brings realism in forex transactions
 Disequilibrium in balance of payment autostabilized
 No need for forex reserve to manage exchange rate
 Prevents real shocks
Reinforces the effectiveness of monetary policy
 expansionary
 contractionary
 Argument against flexible exchange rate
 Exchange rate risk –futures market
 Adverse effect of speculation
 Encourages inflation 11
Far from perfect system, but no better system exists
Linkages between Fiscal Policy and Exchange
Rate
Yincome = Consumption + Investment + Govt + eXport - iMport
Also, Yincome = Consumption + Savings + Taxes

C+S+T= C+I+G+X–M
S+T= I+G+X–M
S+T- I-G = X–M
(S - I) + (T - G) = (X - M)
Balance household + Balance govt. = Balance foreign

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 Foreign Exchange as a Tool of
Monetary Policy

✔ Foreign currency market operations>>>Exchange rate

 In addition to government bonds, RBI buys and sells foreign currency;
 If RBI buys dollars/yen/euros/pounds etc., it increases MS
 If RBI sells forex, it decreases MS
 Buying or selling forex affects the exchange rate
✔ Sterilization
 Sometimes RBI wants to sell foreign currency to support the rupee, but
does not wish the MS to fall
 To do this, RBI uses the rupee it acquires to buy government bonds, thus
putting the rupee back into circulation
 This process of offsetting foreign exchange market operation with an
open-market operation is called sterilization

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 Exchange Rate Adjustments

 Automatic adjustments of to correct BOP disequilibrium

can take place through price and income changes, both
under fixed and flexible exchange regime
 Adjustment to external balance needs expenditure-
reducing and expenditure-switching policies
 Under fixed exchange rate, automatic adjustment
mechanism works through price and money:
unemployment>>fall in prices>>increase in
exports>>gain in employment
 Price adjustments> increasing the price of imports
through raising tariff – now becomes difficult under
WTO – unless temporary
 Income adjustments > contractionary fiscal, wage and 14
monetary policies
 Exchange Rate Adjustments

 A BOP deficit is usually a reflection of monetary

disequilibrium; but the correction mechanism involves
unemployment – more painful than devaluation
 Monetary expansion, in the long run, increases price
level and exchange rate, keeping terms of trade and real
balance constant
 In the short run, monetary expansion increases output
and reduces interest rates, depreciating the currency
 Government can intervene in exchange rate markets to
limit the impact of exchange rate fluctuation on output
and prices

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 Exchange Rate Policy Synchronization

 If policies are not synchronized between countries, they

may pose a major threat to free trade
 When import prices fall due to currency appreciation,
large shifts in demand will occur – domestic workers
become unemployed – leads to pressure for protection –
tariff and quotas
 Flexible exchange regime calls for more interdependence
than fixed exchange rate.
 Through international coordination of interests and
policies, the system works better
 Regular consultation between major currencies

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 India’s Exchange Rate Experience
 In 1972, when the pound was floated, the rupee kept parity with the
British pound
 Between 1975 and 1991 India followed the basket of currency
system, with the British pound as the currency of intervention
 This was a managed float with a margin of +/- 5 percent with a
‘discretionary’ crawling peg
 The basket peg reduced exchange risks compared to the earlier
pound peg, but did not eliminate the risk
 In 1991, during the BOP crisis, the RBI brought about a sizeable
downward adjustment of the rupee value
 LERMS – Liberalized Exchange Rate Management System – 50%
of the currency was freely convertible at market exchange rate, and
50% under a managed float
 1993 Unified Exchange Rate System
 Convertibility of the rupee under current account
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 No full convertibility and capital account convertibility
 Asian Crisis of 1997

 In the spring of 1997, there was the start of the economic crisis
 High growth, high export, high investment, large ST borrowings
 Crisis triggered by sharp fall in export growth in 1996 of
semiconductors (a major item of export from the region)
 Adversely affected the confidence of ST lenders who pulled out
 Rapid outflow of private capital resulting in rapid devaluation and
fall in stock market
 One after another, countries were forced to devalue their currencies
 The crisis spread to Eastern Europe and Russia
 Banks were shut down , stock markets dropped steeply
 Both troubled and sound Asian economies were swept up in the
contagion. Fears of a worldwide depression loomed
 By 1990, most of the economies were back on track
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 Lessons Learned
 Asian economies reaped immense benefits from globalization
 Achieved huge growth
 However the financial sector did not have necessary safeguards
 Rapid expansion of credit during 1994-97, including high-risk
lending by banks
 The bulk of capital inflow initially went into manufacturing and
infrastructure, but later large speculative investments were made in
real estate, stock purchase and consumer creidt
 Banks did not have adequate financial supervisory and regulatory
system keeping pace with the change in global capital flows
 Falling assets price exposed the weakness of the financial system
 India remained largely unaffected
 Prudential norms and improved asset classification and accounting
practices were introduced
 Very little exposure to real estate by Indian banks 19
 Public sector ownership and trade unions reduce efficiency
 Latin American Crises
 In mid 1980s hyperinflation hit Israel and many Latin American
countries (Argentina and Brazil)
 Using a heterodox approach, monetary, exchange rate and fiscal
policies were used with income policies – wages and prices were
frozen. That stopped inflation
 The stabilization succeeded in Israel because it corrected its fiscal
deficit, whereas it did not succeed in Latin America where the fiscal
correction was not sustained.
 Wage and price control alone cannot hold inflation under check if
the underlying fundamentals of fiscal and monetary policy are not
consistent with low inflation.
 Mexico had borrowed too much in the 1980s from the world
markets. Under great pressure because of high interest rates of the
1980s.
 Crisis emerged when foreign lenders lost confidence in Mexico.
Huge financing gap emerged. 20
 Ended in major devaluation and deep depression
 Latin American Crises
 In 1994 and 1995, Mexico underwent a major devaluation from 30
cents to a peso to 15 cents to a peso
 The need for a policy change was predicted well in advance
 Argentina had perpetual currency mismanagement
55 governors of central bank in 55 years
Ten different monies in succession
 In 1990 Argentina chose the currency board system , which
provides the local currency with 100 percent backing in foreign
reserves
 As a result no discretion for central bank to print money to finance
budget deficit
 But public finance and property rights continued to malfunction
 As a result the currency board system crashed and Argentina had to
devalue again
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