EXCHANGE RATE FLUCTUATIONS AND INTERDEPENDENCE

We know that,
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When ER are fully flexible, the govt takes no action in the forex market.
However, typically governments intervene in the forex markets to a lesser or a greater extent.
Forex market intervention occurs when a govt buys or sells forex in an attempt to influence the ER.
It is important to note that since 1973, ER floating has been of the dirty variety. Governments have intervened from time to
times on a very large scale.

Why do Governments Intervene?

Reasons:
1. Because capital flows represent merely unstable expectations and induced movements in ER cause unnecessary changes in
domestic output.
2. Another reason for intervention is that the Central Banks attempt to move real ER in order to affect trade flows {since NX
= f(R)}
3. ER affects domestic inflation. CB sometimes intervenes in the exchange market to prevent the ER form depreciating with
the aim of preventing import prices from rising and thereby helping slow inflation.
Sterilized v/s Non-Sterilized Intervention
Sterilized operations: When a CB say buys foreign exchange issuing domestic money. But then the increase in home money is reversed
by an open market sale of securities. Thus in this case, the home money supply is kept unchanged. It fails to
affect the ERs.
Non-sterilization:

there is a change in the money stock and that is equal to the amount of intervention. Since, non-sterilized
intervention changes money supply, it will affect the ERs.

{Read the examples given in the book)

Interdependence
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Important linkages exist between countries whatever the exchange rate regime. There are spill-over or interdependence effects that
take place under the flexible exchange rate regimes

E.g. US tightens its monetary policy.

US interest rates rise
K flows into US from abroad
$ appreciates and foreign currency depreciates
Appreciation implies loss of competitiveness in the US
World demand shifts from US goods to goods produced by competitor countries
US output and employment thus
Competitors benefit from the depreciation and their output and employment
Thus, monetary tightening tends to promote employment gains abroad at the expense of our own employment.
Now, the spill-over effects also take place through prices.
When US $ appreciates
Import prices in $
Thus, US inflation tends to decline quite rapidly (with $ appreciation)
However, competitor currency depreciates and so prices in those currencies tend to increase
Inflation abroad thus rises.
E.g. US fiscal expansion
$ appreciation
Loss in competitiveness

 in US spending and ROW experiences ed exports

But a US fiscal expansion also implies
$ appreciation
in import prices
reduces the inflation in US.
But since import prices abroad , inflation abroad (imported inflation)
Hence, policy makers abroad must decide whether to accept the higher-employment higher-inflation effects of US policies or whether they should change their
own policies.
Policy Synchronization
When import prices due to currency appreciation or export prices
Large shifts in demand occurs
Domestic workers become unemployed
Foreigners in turn gain the jobs domestic workers lose
there will be pressure in the government for protection (tariffs or quotas) to keep out imports that are artificially cheap.
Under flexible exchange rates there is as much or more interdependence as there is under fixed rates. Because exchange rates are so
flexible and ready to respond, macroeconomic management becomes difficult. Flexible rates are thus, far from being a perfect
system. However, there is no better system since the Bretton Woods system collapsed. Thus, there is a need for international
coordination of interests and policies to make the system work better than it has in the past.
CHOICE OF EXCHANGE RATE REGIME
Target Zones
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Allow ER to float within limited bands and provide for government intervention if the ER passes out of the band. This is
done because it s argued that wide swings in ER from its fundamental value distorts trade flows and risk financial crisis.
Governments typically undertake to set limits of say 10 to 15% in either side of the fundamental equilibrium ER and try to
keep ER from going any further.
Opponent of target zones point out that it is the market itself which gives the equilibrium ER and studies have shown
divergent estimates of equilibrium rates, almost as wide as the target zone itself. Hence, there is no starting point for
discussion. Enforcement of target zones is also another issue as generally it is not feasible for governments to cooperate and
make it happen

Ad Hoc Joint Intervention

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Another less structured way of limiting ER fluctuations

If the rates are far away from their historical average (like the $ in 85 or yen in 96) the governments with good timing can
enter the market when it is known to be very thin i.e. 4:00 Friday afternoon in NY, and buy a large amount of depreciated
currency. This will drive up its price and will create a huge momentum of reversal.
This can work however, the yen episode in 1996 shows evidence that intervention of this kind failed as the markets could
not be convinced that intervention alone was enough.

Dollarization and Currency Boards

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A currency board provides local currency with 100 percent backing in foreign reserves. As a result, there is no discretion for
the central bank, no money to finance budget deficits and no devaluation. For example, Argentinas case in 1990s when its
monetary policy was essentially set by the Fed in Washington. The only freedom Argentina had was that as a sovereign
nation, it could abandon the currency board is its fixed ER became unsustainable. In economies that are mostly functional,
currency boards can be a powerful extra force for enhancing credibility of policies and thus advancing integration in the
world economy.
Dollarization is to do away with domestic money altogether and adopt the dollar (or the euro or the yen). For example,
Ecuadors case in 2000 and El Salvador in 2001. In a world where governments still value sovereignty and its symbols, that is
swallowing a lot. But increasingly countries understand that nationalized politicized central banking is dramatically costly and
hence adopt the dollar.