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 aras Suri 108H39 !shaan Sa"ena 108H43 Gurneet Singh 108H55 Shi#angi $oshi 108H58
%MBA class o& '()(*

+eclaration
We hereby declare that th s ass !nment ent tled "#ore !n $%chan!e &ar'et( s )r tten and subm tted by us under the ' nd !u dance o* &rs. +ar! ,andho-adhyay. .he content o* the -ro/ect s based on secondary data collect on. .h s ass !nment s not co- ed *rom any source or other -ro/ect subm tted *or the s m lar -ur-ose.

A,KN-./E+GEMEN0
.h s ass !nment )ould ha0e been m-oss ble ) thout a host o* hel- n! hands /o n n! to ma'e the load l !hter. .he )or' no) com-leted bears test mony to the r ' nd su--ort )e a0a led dur n! ts *ormat on. We )ould l 'e to be !rate*ul to our *aculty1 &rs +ar! ,andho-adhyay1 *or her !u dance and encoura! n! su--ort. 2lso1 to the l brary at 2m ty ,us ness school *or -ro0 d n! us ) th the boo's )h ch )ere the source o* n*ormat on o* our -ro/ect.

,ontents 0opic
1. #ore !n e%chan!e mar'et3 2n ntroduct on 2. #ore !n e%chan!e nstruments. 3. #actors n*luenc n! $%chan!e rates 4. 4eterm nat on o* $%chan!e Rates 5. #ore !n $%chan!e #orecast n! n -ract ce 6. 5** c al 2ct ons to n*luence $%chan!e Rates 6. #le% ble 07s # %ed $%chan!e rates 8., bl o!ra-hy

age no.
1 4 5 10 19 23 26 29

0he 1oreign E"change Market: An introduction

4

.hat is &oreign e"change rate or e"change rate2 2n e%chan!e rate s s m-ly the -r ce o* one currency n terms o* another. .he -rocess by )h ch that -r ce s determ ned de-ends on the -art cular e%chan!e rate mechan sm ado-ted. 8n a *loat n! rate system1 the e%chan!e rate s determ ned d rectly by mar'et *orces1 and s l able to *luctuate cont nually1 as d ctated by chan! n! mar'et cond t ons. 8n a 9* %ed91 or mana!ed rate system1 the author t es attem-t to re!ulate the e%chan!e rate at some le0el that they cons der a--ro-r ate. Such a system o*ten seems a--eal n! to those )ho are troubled by the uncerta nt es o* the -resent1 h !hly 0olat le1 *loat n! rate en0 ronment. ,ut the cho ce o* e%chan!e rate re! me n0ol0es cons derat ons that e%tend beyond the stab l ty or other) se o* currency -r ces. .h s ) ll become clearer a*ter an e%am nat on o* some *undamentals o* the *ore !n e%chan!e mar'et.

Economics o& the 1oreign E"change Market 8n a *loat n! e%chan!e rate re! me the -r ce o* the dollar1 l 'e any other mar'et:determ ned -r ce1 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 th s <uest on1 let us cons der1 *or llustrat on1 the *actors that determ ne the relat onsh - bet)een the 2ustral an dollar and the =a-anese yen. .he =a-anese re<u re dollars to -ay *or the r m-orts o* !oods and ser0 ces *rom 2ustral a and to *und any n0estment they may ) sh to underta'e n th s country. 2ssume that they obta n these dollars on the *ore !n e%chan!e mar'et by su--ly n! >sell n!? yen n return. So the =a-anese demand *or dollars >m rrored by the su--ly o* yen? s determ ned by the e%-orts to =a-an and our ca- tal n*lo) *rom that country. 5n the other s de o* the mar'et1 the 2ustral an demand *or yen s determ ned 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--ly n! 2ustral an dollars n return. .hus the su--ly o* dollars >m rrored by the demand *or yen? s determ ned by our m-orts *rom =a-an and our ca- tal out*lo) to that country.

8n summary1 then1 the demand *or 2ustral an dollars re*lects the beha0 or o* our e%-orts and ca- tal n*lo)1 )h le the su--ly o* dollars re*lects the beha0 or o* our m-orts and ca- tal out*lo). 8n other )ords1 transact ons on the *ore !n e%chan!e mar'et echo the nternat onal trade and * nanc al transact ons that are summar @ed n the balance o* -ayments. W th n the balance o* -ayments1 the relat onsh - bet)een our e%-orts and m-orts o* !oods and ser0 ces s ca-tured by the balance o* current account1 )h le the relat onsh - bet)een ca- tal n*lo) and ca- tal out*lo) s ca-tured by the balance o* ca- tal account. .he act 0 t es o* nternat onal currency s-eculators a**ect the e%chan!e rate d rectly throu!h the r m-act on ca- tal *lo)s. .he d st n!u sh n! character st c o* a *loat n! e%chan!e rate system s that the -r ce o* a currency ad/usts automat cally to )hate0er le0el s re<u red to e<uate the su--ly o* and demand *or that currency1 thereby clear n! the mar'et. .he lo! c o* the relat onsh - bet)een our nternat onal transact ons and the su--ly and demand *or currenc es m-l es that th s mar'et:clear n!1 or 9e<u l br um91 -r ce also -roduces automat c e<u l br um n the balance o* -ayments. .hat s1 the balance o* current account >)hether -os t 0e1 ne!at 0e1 or @ero? must be -rec sely o**set by the balance >ne!at 0e1 -os t 0e1 or @ero? o* the ca- tal account. Ander *loat n! e%chan!e rates these outcomes are ach e0ed automat cally ) thout the need *or !o0ernment nter0ent on. ,y contrast1 under * %ed e%chan!e rates balance o* -ayments e<u l br um s not the normal cond t on. .hese character st cs o* the *loat n! e%chan!e rate mechan sm ha0e m-ortant m-l cat ons both *or the nature o* our relat onsh - ) th the !lobal en0 ronment1 and *or the -ol cy o-t ons a0a lable to the author t es n mana! n! the economy. Bet us no) cons der some o* these.

!nternational 0ransmission o& Economic Stability 2 *le% ble e%chan!e rate acts as a ' nd o* shoc' absorber that hel-s to nsulate us a!a nst o0erseas d sturbances. .h s s because the relat onsh - bet)een our nternat onal transact ons and 6

the *ore !n e%chan!e mar'et runs n both d rect ons. Bet us su--ose1 *or e%am-le1 that recess on n the =a-anese economy leads to a decl ne n the demand *or 2ustral an e%-orts. 8n tsel*1 th s ) ll tend to reduce econom c act 0 ty n 2ustral a. ,ut th s tendency ) ll be o**set by an assoc ated de-rec at on o* the dollar1 )h ch ) ll nduce an e%-ans on o* e%-orts1 a contract on o* m-orts1 and -erha-s an ncrease n net ca- tal n*lo)1 all o* )h ch ) ll hel- to cush on the 2ustral an economy a!a nst recess on. 2n analo!ous mechan sm )ould o-erate to reduce the m-act o* an n t al decl ne n =a-anese n0estment n 2ustral a. ,oth cases llustrate the role o* e%chan!e rate *le% b l ty n nsulat n! our economy to some de!ree a!a nst nternat onal econom c nstab l ty. ,y the same reason n!1 *loat n! e%chan!e rates also hel- to d m n sh the nternat onal transm ss on o* our o)n domest c econom c nstab l ty. ,haracteristics o& the 1oreign E"change Market .he #ore% mar'et does not e% st -hys cally1 t s a *rame)or' )here -art c -ants are connected by com-uters1 tele-hones and tele% >SW8#.? and o-erates n most * nanc al 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 *ac l tate trade occurr n! 24 hours a day mo0 n! *rom one ma/or mar'et to another. &ost e%chan!es o* currency are made throu!h ban' de-os ts .e. trans*erred electron cally *rom one account to another. .he 0olume o* *ore !n e%chan!e transact ons )orld) de s assumed to be a--ro% mately AS4 2 tr ll on -er day. .he a0era!e da ly turno0er n the South 2*r can mar'et s R11 b ll on -er day and Standard ,an' s the reco!n sed leader n the domest c *ore !n e%chan!e mar'et1 handl n! more than 30D o* South 2*r ca9s *ore !n e%chan!e 0olume. .he #ore% mar'et s an o0er:the: counter mar'et .e. trad n! n * nanc al nstruments that are not l sted or a0a lable on an o** c ally reco!n sed e%chan!e >such as the =S$ C =ohannesbur! Stoc' $%chan!e?1 but traded n d rect ne!ot at on bet)een buyers and sellers. .rad n! ta'es -lace tele-hon cally or electron cally.

.hy do 3e make use o& the 1oreign E"change Market2

.rad n! n a domest c mar'et s substant ally d **erent *rom do n! bus ness n an o**shore mar'et. 8n the com-le% )orld o* nternat onal trade1 merchants *ace a number o* r s's that need to be mana!ed n order to ensure the success o* the r cross C border transact ons. 8n order to -rotect themsel0es1 these cor-orat ons a--ly hed! n! techn <ues us n! 0ar ous *ore !n e%chan!e nstruments and -roducts n order to ne!ate the m-acts o* e%chan!e rate *luctuat ons. Success*ul com-an es em-loy e**ect 0e r s' mana!ement techn <ues )hen ma' n! bus ness dec s ons1 and e0aluate commerc al r s' n an e%-l c t and lo! cal manner n order to o**set * nanc al loss occas oned by the 0olat l ty n e%chan!e rates >currency r s'?. .ho are the 1oreign E"change Market articipants2 Eommerc al ,an's -art c -ate n the mar'et by o**er n! to buy and sell *ore !n e%chan!e on behal* o* the r reta l or )holesale customers as a -art o* the r * nanc al ser0 ce. .hey also trade n *ore !n e%chan!e as an ntermed ary and mar'et ma'er. >2 mar'et ma'er <uotes a buy and sell -r ce on a currency or * nanc al nstrument ho- n! to ma'e a -ro* t on the s-read .e. the d **erence bet)een the buy n! and the sell n! -r ce?. 5ther * nanc al 8nst tut ons1 such as ,ro'ers >8nst tut onal 8n0estors1 8nsurance com-an es1 Fens on1 &utual and Hed!e #und &ana!ers? need to mana!e 0ar ous -ort*ol os on behal* o* the r cl ents1 and thus -art c -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 -art c -ants and char!e comm ss on or a bro'era!e *ee *or ser0 ces rendered. Eor-orat ons buy and sell *ore !n e%chan!e !enerally to *ac l tate trade1 or as a result o* a trade done and also to hed!e currency e%-osures that e% st due to a -art cular trade conducted. .hese cor-orat ons !enerally cons st o* e%-orters and m-orters. Eentral ,an's can somet mes nter0ene n the *ore !n e%chan!e mar'et n order to m-lement monetary -ol c es.

1oreign E"change !nstruments

8

2 number o* *ore !n e%chan!e nstruments ha0e been des !ned *or e**ect 0e hed! n! as )ell as enhancement o* returns. .he *ollo) n! nstruments and -roducts are most common to the #ore !n $%chan!e &ar'et to *ac l tate nternat onal trade and ) ll be co0ered n *uture #ore% ,ullet ns3 S-ot transact ons1 #or)ard .ransact ons >#$Es?1 5-t ons >4er 0at 0es o* e%chan!e rates?1 8nternat onal money trans*ers1 +uarantees1 Eommerc al Eustomer #ore !n Eurrency accounts1 4ocumentary Ered t and Eollect ons1

1actors in&luencing e"change rates

#ore !n e%chan!e rates are e%tremely 0olat le and t s ncumbent on those n0ol0ed ) th *ore !n e%chan!e : e ther as a -urchaser1 seller1 s-eculator or nst tut on : to 'no) )hat causes rates to mo0e. 2ctually1 there are a 0ar ety o* *actors : mar'et sent ment1 the state o* the economy1 !o0ernment -ol cy1 demand and su--ly and a host o* others. .he more m-ortant *actors that n*luence e%chan!e rates are d scussed 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!then n! 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* the r o)n currency. .he result s usually a stren!then n! n ts 0alue. Political and Psychological Factors: Fol t cal or -sycholo! cal *actors are bel e0ed to ha0e an n*luence on e%chan!e rates. &any currenc es ha0e a trad t on o* beha0 n! n a -art cular )ay such as S) ss *rancs )h ch are 'no)n as a re*u!e or sa*e ha0en currency )h le the dollar mo0es >e ther u- or do)n? )hene0er there s a -ol t cal cr s s any)here n the )orld. $%chan!e rates can also *luctuate * there s a chan!e n !o0ernment. Some t me bac'1 8nd as *ore !n e%chan!e rat n! )as do)n!raded because o* -ol t cal nstab l ty 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 9

El nton )as m-eached1 the AS dollar )ea'ened. 4ur n! 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 econom c e%-ectat ons. 2*ter the 1999 bud!et n 8nd a there )as an e%-ectat on that the ru-ee )ould *all by 6D to 9D. S nce such e%-ectat ons a**ect the e%ternal 0alue o* the ru-ee1 all econom c data : the balance o* -ayments1 e%-ort !ro)th1 n*lat on rates and the l 'es : are analysed and ts l 'ely e**ect on e%chan!e rates s e%am ned. 8* the econom c do)nturn s not as bad as ant c -ated the rate can e0en a--rec ate. .he mo0ement really de-ends on the "mar'et sent ment( : the mood o* the mar'et : and ho) much the mar'et has reacted or d scounted the ant c -ated7e%-ected n*ormat on. Inflation Rates : 8t s ) dely held that e%chan!e rates mo0e n the d rect on re<u red to com-ensate *or relat 0e n*lat on rates. #or nstance1 * a currency s already o0er0alued1 .e. stron!er than )hat s )arranted by relat 0e n*lat on rates1 de-rec at on su** c ent enou!h to correct that -os t on can be e%-ected and 0 ce 0ersa. 8t s necessary to note that an e%chan!e rate s a relat 0e -r ce and hence the mar'et )e !hs all the relat 0e *actors n relat 0e terms > n relat on to the counter-art countr es?. .he underly n! reason n! beh nd th s con0 ct on s that a relat 0ely h !h rate o* n*lat on reduces a countrys com-et t 0eness and )ea'ens ts ab l ty to sell n nternat onal mar'ets. .h s s tuat on1 n turn1 ) ll )ea'en the domest c currency by reduc n! the demand or e%-ected demand *or t and ncreas n! the demand or e%-ected demand *or the *ore !n currency > ncrease n the su--ly o* domest c 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 nternat onal trade. .h s occurs due to a 0ar ety o* reasons : both -os t 0e and ne!at 0e. When 8nd a be!an ts econom c l beral sat on and n0 ted #ore !n 8nst tut onal 8n0estors >#88s? to -urchase e<u ty shares n 8nd an com-an es1 b ll ons o* AS dollars came nto the country stren!then n! the currency. 8n 1996 and 19961 #88s too' se0eral b ll on AS dollars out o* the country )ea'en n! the currency. .hese )ere ca- tal out*lo)s. 5ne o* the reasons -o-ularly bel e0ed *or the ru-ee not de-rec at n! n the manner other South:east 2s an currenc es d d n 1996:98 )as because the ru-ee )as not con0ert ble on the "ca- tal account(. 10

 Speculation 3 S-eculat on n a currency ra ses 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 m ll on1 t ) ll ra se the 0alue o* the AS dollar s !n * cantly. 8* a *e) others do so too1 the -r ce o* the AS dollar ) ll r se e0en *urther a!a nst the Henya sh ll n!. .he most *amous s-eculator n *ore !n currency s &r +eor!e Soros )ho made o0er a b ll on -ounds sterl n! n $uro-e >by correctly -red ct n! the de0aluat on o* the -ound? and then s bel e0ed to ha0e tr !!ered the *ree *all o* the currenc es o* South:east 2s a. . Balance of Payments 3 2s ment oned earl er1 a net n*lo) o* *ore !n currency tends to stren!then the home currency 0 s:J:0 s other currenc es. .h s s because the su--ly o* the *ore !n currency ) ll be n e%cess o* demand. 2 !ood )ay o* ascerta n n! th s )ould be to chec' the balance o* -ayments. 8* the balance o* -ayments s -os t 0e and *ore !n e%chan!e reser0es are ncreas n!1 the home currency ) ll become stron!er. overnment!s Monetary and Fiscal Policies : +o0ernments1 throu!h the r monetary and * scal -ol c es a**ect nternat onal trade1 the trade balance and the su--ly and demand *or a currency. 8ncreas n! the su--ly o* money ra ses -r ces and ma'es m-orts attract 0e. # scal sur-luses ) ll slo) econom c !ro)th and th s ) ll reduce demand *or m-orts and encoura!e e%-orts. .he e**ect 0eness o* the -ol cy de-ends on the -r ce and ncome elast c t es o* demand *or the -art cular !oods. H !h -r ce elast c ty o* demand means the 0olume o* a !ood s sens t 0e to a chan!e n -r ce. &onetary and * scal -ol cy su--ort the currency throu!h a reduct on n n*lat on. .hese also a**ect e%chan!e rate throu!h the ca- tal account. Get ca- tal n*lo)s su--ly d rect 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 -ol cy s *ollo)ed. .o th s e%tent they could ncrease or decrease money su--ly. #or e%am-le1 the Reser0e ,an' o* 8nd a1 to curb n*lat on1 restr cted and cut money su--ly. 8n Henya1 the central ban' n order to attract *ore !n money nto the country s o**er n! 0ery h !h rates on ts treasury b lls. 8n order to ma nta n e%chan!e rates at a certa n -r ce the central ban' ) ll also nter0ene e ther by buy n! *ore !n currency >)hen there s an e%cess n the su--ly o* *ore !n e%chan!e? and sell n! *ore !n currency >)hen demand *or *ore !n e%chan!e e%ceeds su--ly?. .h s s 'no)n as Kcentral ban' nter0ent on. 8t must be noted that the ob/ect 0e o* monetary -ol cy s to ma nta n stab l ty and econom c !ro)th and central

11

ban's are e%-ected to : by ncreas n!7decreas n! money su--ly1 ra s n!7lo)er n! nterest rates or by o-en mar'et o-erat ons : ma nta n stab l ty. Exchange Rate Policy and Intervention3 $%chan!e rates are also n*luenced1 n no small measure1 by e%-ectat on o* chan!e n re!ulat ons relat n! to e%chan!e mar'ets and o** c al nter0ent on. 5** c al nter0ent on can smoothen an other) se d sorderly mar'et. 2s e%-la ned be*ore1 nter0ent on s the buy n! or sell n! o* *ore !n currency to ncrease or decrease ts su--ly. Eentral ban's o*ten nter0ene to ma nta n stab l ty. 8t has also been e%-er enced that * the author t es attem-t to hal*:heartedly counter the mar'et sent ments throu!h nter0ent on n the mar'et1 ult mately 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 **erent al bet)een ma/or currenc es. 8n th s res-ect the !ro) n! nte!rat on o* * nanc al mar'ets o* ma/or countr es1 the re0olut on n telecommun cat on *ac l t es1 the !ro)th o* s-ec al sed asset mana! n! a!enc es1 the dere!ulat on o* * nanc al mar'ets by ma/or countr es1 the emer!ence o* *ore !n trad n! as -ro* t centres -er se and the tremendous sco-e *or band)a!on and s<uar n! e**ects on the rates1 etc. ha0e accelerated the -otent al *or e%chan!e rate 0olat l ty. Henya ntr ns cally has a 0ery )ea' economy but the rates o**ered ) th n the country ha0e al)ays been 0ery h !h. .o llustrate th s -o nt the treasury b ll rate n Se-tember 1998 )as as h !h as 23D. H !h nterest rates attract s-eculat 0e ca- tal mo0es so the announcements made by the #ederal Reser0e on nterest rates are usually ea!erly a)a ted : an ncrease n the same ) ll cause an n*lo) o* *ore !n currency and the stren!then n! o* the AS dollar. "ariffs and #uotas 3 .ar **s and <uotas e% st to -rotect a countrys *ore !n e%chan!e by reduc n! demand. . ll be*ore l beral sat on1 8nd a *ollo)ed a -ol cy o* tar **s and restr ct ons on m-orts. Lery *e) tems )ere -erm tted to be *reely m-orted. 2dd t onally1 h !h customs dut es )ere m-osed to d scoura!e m-orts and to -rotect the domest c ndustry. .ar **s and <uotas are not -o-ular nternat onally as they tend to close mar'ets. When 8nd a l *ted ts barr ers1 se0eral ndustr es such as the m n steel and the scra- metal ndustr es colla-sed > m-orted scra- became chea-er than the domest c one?. Muotas are not restr cted to de0elo- n! countr es. .he An ted 12

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 us n! d rect controls bas cally to -rotect t. Eurrency control s the restr ct on o* us n! or a0a l n! o* *ore !n currency at home7abroad. 8n 8nd a1 u- to l beral @at on n the n net es there )as 0ery se0ere e%chan!e control. 2ccess to *ore !n currency )as t !htly controlled and the same )as released only *or -erm tted -ur-oses. .h s )as because 8nd an e%-orts had not ta'en o** and there )ere st ll lar!e m-orts. .here are se0eral countr es that ma nta n the r rates at art * c al le0els such as ,an!ladesh. 8nd a s no) *ully1 con0ert ble on the current account but not as yet on the ca- tal account. .h s1 to an e%tent1 -oss bly sa0ed 8nd a )hen the run on currenc es too' -lace n 2s a n 1996. 8* the 8nd an ru-ee )as *ully con0ert ble and there )ere no e%chan!e control restr ct ons1 the ru-ee )ould ha0e been o-en *or s-eculat on. .here )ould ha0e been lar!e out*lo)s at a t me o* concern result n! n a sno)ball n! -lun!e n ts 0alue. 2s lon! as the -ar 0alue system -re0a led1 the rates could not !o beyond the u--er and lo)er nter0ent on -o nts. .he only real <uest on under the * %ed rate system )as )hether the balance o* -ayments and *ore !n e%chan!e reser0es had deter orated to such an e%tent that de0aluat on )as mm nent or -oss ble. Eountr es ) th stron! balance o* -ayments and reser0e -os t ons )ere hardly called u-on to re0alue the r currenc es. Hence1 a )atch had to be 'e-t only on de* c t countr es. Ho)e0er1 under !eneral @ed *loat n! re! me1 e%chan!e rates are n*luenced by a mult tude o* econom c1 * nanc al1 -ol t cal and -sycholo! cal *actors. ,ut the relat 0e s !n * cance o* any o* these *actors can 0ary *rom t me to t me ma' n! t d ** cult to -red ct -rec sely ho) any s n!le *actor ) ll n*luence the rates and by ho) much.

13

+etermination o& E"change 4ates

8n s m-le terms1 t s the nteract on o* su--ly and demand *actors *or t)o currenc es n the mar'et that determ nes the rate at )h ch they trade. ,ut )hat *actors n*luence the many thousands o* dec s ons made each day to buy or sell a currency; Ho) do chan!es n su--ly and demand cond t ons e%-la n the -ath o* an e%chan!e rate o0er the course o* a day1 a month1 or a year; .h s com-le% ssue has been e%tens 0ely stud ed n econom c l terature and ) dely d scussed amon! n0estors1 o** c als1 academ c ans1 traders1 and others. St ll1 there are no de* n t 0e ans)ers. L e)s on e%chan!e rate determ nat on d **er and ha0e chan!ed o0er t me. Go s n!le a--roach -ro0 des a sat s*actory e%-lanat on o* e%chan!e rate mo0ements1 -art cularly short: and med um:term mo0ements1 s nce the ad0ent o* ) des-read *loat n! n the early 1960s. .hree as-ects o* e%chan!e rate determ nat on are d scussed belo). # rst1 there s a br e* descr -t on o* some o* the broad a--roaches to e%chan!e rate determ nat on. Second1 there are some comments on the -roblems o* e%chan!e rate *orecast n! n -ract ce. .h rd1 central ban' nter0ent on and ts e**ects on e%chan!e rates are d scussed. Some a--roaches to e%chan!e rate determ nat on3 "he Purchasing Po$er Parity %pproach Furchas n! Fo)er Far ty >FFF? theory holds that n the lon! run1 e%chan!e rates ) ll ad/ust to e<ual @e the relat 0e -urchas n! -o)er o* currenc es. .h s conce-t *ollo)s *rom the la) o* one -r ce1 )h ch holds that n com-et t 0e mar'ets1 dent cal !oods ) ll sell *or dent cal -r ces )hen 0alued n the same currency. .he la) o* one -r ce relates to an nd 0 dual -roduct. 2 !eneral @at on o* that la) s the absolute 0ers on o* FFF1 the -ro-os t on that e%chan!e rates ) ll e<uate nat ons o0erall -r ce le0els. &ore commonly used than absolute FFF s the conce-t o* relat 0e FFF1 )h ch *ocuses on 14

chan!es n -r ces and e%chan!e rates1 rather than on absolute -r ce le0els. Relat 0e FFF holds that there ) ll be a chan!e n e%chan!e rates -ro-ort onal to the chan!e n the rat o o* the t)o nat ons -r ce le0els1 assum n! no chan!es n structural relat onsh -s. .hus1 * the A.S. -r ce le0el rose 10 -ercent and the =a-anese -r ce le0el rose 5 -ercent1 the A.S. dollar )ould de-rec ate 5 -ercent1 o**sett n! the h !her A.S. n*lat on and lea0 n! the relat 0e -urchas n! -o)er o* the t)o currenc es unchan!ed. FFF s based n -art on some unreal st c assum-t ons3 that !oods are dent calN that all !oods are tradableN that there are no trans-ortat on costs1 n*ormat on !a-s1 ta%es1 tar **s1 or restr ct ons o* tradeN and O m-l c tly and m-ortantlyOthat e%chan!e rates are n*luenced only by relat 0e n*lat on rates. ,ut contrary to the m-l c t FFF assum-t on1 e%chan!e rates also can chan!e *or reasons other than d **erences n n*lat on rates. Real e%chan!e rates can and do chan!e s !n * cantly o0er t me1 because o* such th n!s as ma/or sh *ts n -roduct 0 ty !ro)th1 ad0ances n technolo!y1 sh *ts n *actor su--l es1 chan!es n mar'et structure1 commod ty shoc's1 shorta!es1 and booms. 8n add t on1 the relat 0e 0ers on o* FFF su**ers *rom measurement -roblems3What s a !ood start n! -o nt1 or base -er od; Wh ch s the a--ro-r ate -r ce nde%; Ho) should )e account *or ne) -roducts1 or chan!es n tastes and technolo!y; FFF s ntu t 0ely -laus ble and a matter o* common sense1 and t undoubtedly has some 0al d ty Os !n * cantly d **erent rates o* n*lat on should certa nly a**ect e%chan!e rates. FFF s use*ul n assess n! lon!:term e%chan!e rate trends and can -ro0 de 0aluable n*ormat on about lon!:run e<u l br um. ,ut t has not met ) th much success n -red ct n! e%chan!e rate mo0ements o0er short: and med um:term hor @ons *or ) dely traded currenc es. 8n the short term1 FFF seems to a--ly best to s tuat ons )here a country s e%-er enc n! 0ery h !h1 or e0en hy-er n*lat on1 n )h ch lar!e and cont nuous -r ce r ses 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 ser0 cesO and -ostulates that e%chan!e rate chan!es are determ ned by nternat onal d **erences n -r ces1 or chan!es n -r ces1 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 !u de n the determ nat on o* the a--ro-r ate e%chan!e rate. ,ut n todays )orld1 t s !enerally a!reed that t s essent al to loo' at the ent re balance o* -aymentsOboth current and ca- tal account transact onsO n assess n! *ore !n e%chan!e *lo)s and the r role n the determ nat on o* e%chan!e rates. =ohn W ll amson and others ha0e de0elo-ed the conce-t o* the "*undamental e<u l br um e%chan!e rate1( or #$$R1 en0 sa!ed as the e<u l br um e%chan!e rate that )ould reconc le a nat ons nternal and e%ternal balance. 8n that system1 each country )ould comm t tsel* to a macroeconom c strate!y des !ned to lead1 n the med um term1 to " nternal balance(Ode* ned as unem-loyment at the natural rate and m n mal n*lat onOand to "e%ternal balance(Ode* ned as ach e0 n! the tar!eted current account balance. $ach country )ould be comm tted to hold n! ts e%chan!e rate ) th n a band or tar!et @one around the #$$R1 or the le0el needed to reconc le nternal and e%ternal balance dur n! the nter0en n! ad/ustment -er od. .he conce-t o* #$$R1 as an e<u l br um e%chan!e rate to reconc le nternal and e%ternal balance1 s a use*ul one. ,ut there are -ract cal -roblems n calculat n! #$$Rs..here s no un <ue ans)er to )hat const tutes the #$$RN de-end n! on the -art cular assum-t ons1 models1 and econometr c methods used1 d **erent analysts could come to <u te d **erent results. .he authors reco!n @e th s d ** culty1 and ac'no)led!e that some allo)ance should be made by )ay o* a tar!et band around the #$$R.W ll amson has su!!ested that #$$R calculat ons could not real st cally /ust *y e%chan!e rate bands narro)er than -lus or m nus 10 -ercent.

16

.he 8&#1 )h le !enerally a!ree n! that t s not -oss ble to dent *y -rec se "e<u l br um(0alues *or e%chan!e rates and that -o nt est mates o* not onal e<u l br um rates should !enerally be a0o ded1 does use a macroeconom c balance methodolo!y to under- n ts nternal 8&# mult lateral sur0e llance. .h s mehodolo!y1 )h ch s used *or assess n! the "a--ro-r ateness(o* current account -os t ons and e%chan!e rates *or ma/or ndustr al countr es1 s descr bed n ,o% 11:1.6 "he Monetary %pproach .he monetary a--roach to e%chan!e rate determ nat on s based on the -ro-os t on that e%chan!e rates are establ shed throu!h the -rocess o* balanc n! the total su--ly o*1 and the total demand *or1 the nat onal money n each nat on. .he -rem se s that the su--ly o* money can be controlled by the nat ons monetary author t es1 and that the demand *or money has a stable and -red ctable l n'a!e to a *e) 'ey 0ar ables1 nclud n! an n0erse relat onsh - to the nterest rateOthat s1 the h !her the nterest rate1 the smaller the demand *or money. 8n ts s m-lest *orm1 the monetary a--roach assumes that3 -r ces and )a!es are com-letely *le% ble n both the short and lon! run1 so that FFF holds cont nuously1 that ca- tal s *ully mob le across nat onal borders1 and that domest c and *ore !n assets are -er*ect subst tutes. Start n! *rom e<u l br um n the money and 16

*ore !n e%chan!e mar'ets1 * the A.S. money su--ly ncreased1 say1 20 -ercent1 )h le the =a-anese money su--ly rema ned stable1 the A.S. -r ce le0el1 n t me1 )ould r se 20 -ercent and the dollar )ould de-rec ate 20 -ercent n terms o* the yen. 8n th s s m-l * ed 0ers on1 the monetary a--roach comb nes the FFF theory ) th the <uant ty theory o* moneyO ncreases or decreases n the money su--ly lead to -ro-ort onate ncreases or decreases n the -r ce le0el o0er t me1 ) thout any -ermanent e**ects on out-ut or nterest rates. &ore so-h st cated 0ers ons rela% some o* the restr ct 0e assum-t onsO*or e%am-le1 -r ce *le% b l ty and FFF may be assumed not to hold n the short runObut ma nta n the *ocus on the role o* nat onal monetary -ol c es. $m- r cal tests o* the monetary a--roachO s m-le or so-h st catedOha0e *a led to -ro0 de an ade<uate e%-lanat on o* e%chan!e rate mo0ements dur n! the *loat n! rate -er od. .he a--roach o**ers only a -art al 0 e) o* the *orces n*luenc n! e%chan!e ratesO t assumes a)ay the role o* nonmonetary assets such as bonds1 and t ta'es no e%-l c t account o* su--ly and demand cond t ons n !oods and ser0 ces mar'ets. 4es- te ts l m tat ons1 the monetary a--roach o**ers 0ery use*ul ns !hts. 8t h !hl !hts the m-ortance o* monetary -ol cy n n*luenc n! e%chan!e rates1 and correctly )arns that e%cess 0e monetary e%-ans on leads to currency de-rec at on. .he monetary a--roach also -ro0 des a bas s *or e%-la n n! e%chan!e rate o0ershoot n!Oa s tuat on o*ten obser0ed n e%chan!e mar'ets n )h ch a -ol cy mo0e can lead to an n t al e%chan!e rate mo0e that e%ceeds the e0entual chan!e m-l ed by the ne) lon!:term s tuat on. 8n the conte%t o* monetary a--roach models that ncor-orate short:term st c' ness n -r ces1 e%chan!e rate o0ershoot n! can occur because -r ces o* * nanc al assetsO nterest and e%chan!e ratesOres-ond more <u c'ly to -ol cy mo0es than does the -r ce le0el o* !oods and ser0 ces. .hus1 *or e%am-le1 a money su--ly ncrease >or decrease? n the An ted States can lead to a !reater tem-orary dollar de-rec at on >a--rec at on? as domest c nterest rates decl ne >r se? tem-orar ly be*ore the ad/ustment o* the -r ce le0el to the ne) lon!:run e<u l br um s com-leted and nterest rates return to the r or ! nal le0els.

18

"he Portfolio Balance %pproach

.he -ort*ol o balance a--roach ta'es a shorter:term 0 e) o* e%chan!e rates and broadens the *ocus *rom the demand and su--ly cond t ons *or money to ta'e account o* the demand and su--ly cond t ons *or other * nanc al assets as )ell. Anl 'e the monetary a--roach1 the -ort*ol o balance a--roach assumes that domest c and *ore !n bonds are not -er*ect subst tutes. 2ccord n! to the -ort*ol o balance theory n ts s m-lest *orm1 * rms and nd 0 duals balance the r -ort*ol os amon! domest c money1 domest c bonds1 and *ore !n currency bonds1 and they mod *y the r -ort*ol os as cond t ons chan!e. 8t s the -rocess o* e<u l brat n! the total demand *or1 and su--ly o*1 * nanc al assets n each country that determ nes the e%chan!e rate. $ach nd 0 dual and * rm chooses a -ort*ol o to su t ts needs1 based on a 0ar ety o* cons derat onsOthe holders )ealth and tastes1 the le0el o* domest c and *ore !n nterest rates1 e%-ectat ons o* *uture n*lat on1 nterest rates1 and so on. 2ny s !n * cant chan!e n the underly n! *actors ) ll cause the holder to ad/ust h s -ort*ol o and see' a ne) e<u l br um. .hese act ons to balance -ort*ol os ) ll n*luence e%chan!e rates. 2ccord n!ly1 a nat on ) th a sudden ncrease n money su--ly )ould mmed ately -urchase both domest c and *ore !n bonds1 result n! n a decl ne n both countr es nterest rates1 and1 to the e%tent o* the sh *t to *ore !n bonds1 a de-rec at on n the nat ons home currency. 50er t me1 the de-rec at on n the home currency )ould lead to !ro)th n the nat ons e%-orts and a decl ne n ts m-orts1 and thus1 to an m-ro0ed trade balance and re0ersal o* -art o* the or ! nal de-rec at on. 2s yet1 there s no un * ed theory o* e%chan!e rate determ nat on based on the -ort*ol o balance a--roach that has -ro0ed rel able n *orecast n!. 8n *act1 results o* em- r cal tests o* the -ort*ol o balance a--roach do not com-are *a0orably ) th those *rom s m-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-os t on o* -r 0ate sector -ort*ol os.

20

21

Ge0ertheless1 the -ort*ol o balance a--roach o**ers a use*ul *rame)or' *or study n! e%chan!e rate determ nat on. W th ts *ocus on a broad menu o* assets1 th s a--roach -ro0 des r cher ns !hts than the monetary a--roach nto the *orces n*luenc n! e%chan!e rates. 8t also enables *ore !n e%chan!e rates to be seen l 'e asset -r ces n other mar'ets1 such as the stoc' mar'et or bond mar'et1 )here rates are n*luenced1 not only by current cond t ons1 but to a !reat e%tent by mar'et e%-ectat ons o* *uture e0ents. 2s ) th other * nanc al assets1 e%chan!e rates chan!e cont nuously as the mar'et rece 0es ne) n*ormat on about current cond t ons and n*ormat on that a**ects e%-ectat ons o* the *uture. .he random character o* these asset -r ce mo0ements does not rule out rat onal -r c n!. 8ndeed1 t s -ersuas 0ely ar!ued that th s s the result to be e%-ected n a )ell *unct on n! * nanc al mar'et. ,ut n such an en0 ronment1 e%chan!e rate chan!es can be lar!e and 0ery d ** cult to -red ct1 as mar'et -art c -ants try to /ud!e the e%-ected real rates o* return on the r domest c assets n com-ar son ) th alternat 0es n other currenc es. 5o3 Good Are the 6arious Approaches2 .he a--roaches noted abo0e are some o* the most !eneral and most *am l ar ones1 but there are many others1 *ocus n! on d **erent als n real nterest rates1 on * scal -ol c es1 and on other elements.

22

.he research on th s to- c has been o* !reat 0alue n enhanc n! our understand n! o* lon!:run e%chan!e rate trends and the ssues n0ol0ed n est mat n! "e<u l br um( rates. 8t has hel-ed us understand 0ar ous as-ects o* e%chan!e rate beha0 or and -art cular e%chan!e rate e- sodes. Pet none o* the a0a lable em- r cal models has -ro0ed ade<uate *or ma' n! rel able -red ct ons o* the course o* e%chan!e rates o0er a -er od o* t me. Research thus *ar has not been able to * nd stable and s !n * cant relat onsh -s bet)een e%chan!e rates and any econom c *undamentals ca-able o* cons stently -red ct n! or e%-la n n! short:term rate mo0ements.

23

1oreign e"change &orecasting in practice

&ost o* the a--roaches to e%chan!e rate determ nat on tell only -art o* the storyOl 'e the se0eral bl nd*olded men touch n! d **erent -arts o* the ele-hants bodyOand other1 more com-rehens 0e e%-lanat ons cannot1 n -ract ce1 be used *or -rec se *orecast n!. We do not yet ha0e a )ay o* br n! n! to!ether all o* the *actors that hel- determ ne the e%chan!e rate n a s n!le com-rehens 0e a--roach that ) ll -ro0 de rel able short: to med um:term -red ct ons. .he e%chan!e rate s a -er0as 0e and com-le% mechan sm1 n*luenc n! and be n! n*luenced by many d **erent *orces1 ) th the e**ects and the relat 0e m-ortance o* the d **erent n*luences cont nuously chan! n! as cond t ons chan!e. .o the e%tent that trade *lo)s are a *orce n the mar'et1 com-et t 0eness s ob0 ously m-ortant to the e%chan!e rate1 and the many *actors a**ect n! com-et t 0eness must be cons dered..o the e%tent that the money mar'et s a *actor1 the *ocus should be on short:term nterest rates1 and on monetary -ol cy and other *actors n*luenc n! those shortterm nterest rates. .o the e%tent that -ort*ol o ca- tal *lo)s matter1 the *ocus should be broadened to nclude bond mar'et cond t ons and lon!:term nterest rates. Fart cularly at t mes o* !reat nternat onal tens on1 all other *actors a**ect n! the dollar e%chan!e rate may be o0er)helmed by cons derat ons o* "sa*e ha0en.( 8ndeed1 countless *orces n*luence the e%chan!e rate1 and they are sub/ect to cont nuous and un-red ctable chan!es o0er t me1 by a mar'et that s broad and hetero!enous n terms o* the -art c -ants1 the r nterests1 and the r t me *rames. W th cond t ons al)ays chan! n!1 the m-act o* -art cular e0ents and the res-onse to -art cular -ol cy act ons can 0ary !reatly ) th the c rcumstances at the t me. 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 ant c -ated1 )hat subse<uent mo0es are e%-ected1 and the m-l cat ons *or other * nanc al mar'ets1 dec s ons1 or !o0ernment -ol cy mo0es. S m larly1 the results o* e%chan!e rate chan!es are not al)ays -red ctable3 8m-orters m !ht e%-ect to -ay more * the r domest c currency de-rec ates1 but not * *ore !n -roducers are 24

"-r c n! to mar'et( n order to establ sh a beachhead or ma nta n a mar'et share1 or * the m-orters or e%-orters had ant c -ated the rate mo0e and had acted n ad0ance to -rotect themsel0es *rom t. Gonetheless1 those -art c -at n! n the mar'et must ma'e the r *orecasts1 m-l c tly and e%-l c tly1 day a*ter day1 all o* the t me. $0ery - ece o* n*ormat on that becomes a0a lable can be the bas s *or an ad/ustment o* each -art c -ants 0 e)-o nt1 or e%-ectat onsO n 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 bas s *or countless assessments o* the s !n * cance o* that e0ent1 and countless *orecasts o* ts m-act n number o* bas s -o nts. .hose )ho *orecast *ore !n e%chan!e rates o*ten are d 0 ded nto those )ho use "techn cal( analys s1 and those )ho rely on analys s o* "*undamentals1( such as +4F1 n0estment1 sa0 n!1 -roduct 0 ty1 n*lat on1 balance o* -ayments -os t on1 and the l 'e. .echn cal analys s assumes certa n short:term and lon!er:term -atterns n e%chan!e rate mo0ements. 8t d **ers *rom the "random )al'( -h loso-hyOthe bel e* that all -resently a0a lable n*ormat on has been absorbed nto the -resent e%chan!e rate and that1 the ne%t - ece o* n*ormat on as )ell as the d rect on o* the ne%t rate mo0e s random1 ) th a 50 -ercent chance the rate ) ll r se1 and 50 -ercent chance t ) ll decl ne.

25

Gearly all traders ac'no)led!e the r use o* techn cal analys s and charts. 2ccord n! to sur0eys1 a ma/or ty say they em-loy techn cal analys s to a !reater e%tent than "*undamental( analys s1 and

26

that they re!ard t as more use*ul than *undamental analys sOa contrast to t)enty years a!o )hen most sa d they rel ed many more hea0 ly on *undamental analys s. Ferha-s traders use techn cal analys s n -art because1 at least su-er* c ally1 t seems s m-ler1 or because the data are more current and t mely. Ferha-s they use t because traders o*ten ha0e a 0ery short:term t me *rame and are nterested n 0ery short:term mo0es. .hey m !ht a!ree that "*undamentals( determ ne the course o* -r ces n the lon! run1 but they may not re!ard that as rele0ant to the r mmed ate tas'1 -art cularly s nce many "*undamental( data become a0a lable only ) th lon! la!s and are o*ten sub/ect to ma/or re0 s ons. Ferha-s traders th n' techn cal analys s ) ll be e**ect 0e n -art because they 'no) many other mar'et -art c -ants are rely n! on t. St ll1 s-ott n! trends s o* real m-ortance to tradersO"a trend s a *r end( s a comment o*ten heardOand techn cal analys s can add some d sc -l ne and so-h st cat on to the -rocess o* d sco0er n! and *ollo) n! a trend. .echn cal analys s may add more ob/ect 0 ty to ma' n! the d ** cult dec s on on )hen to ! 0e uon a -os t onOenabl n! one to see that a trend has chan!ed or run ts course1 and t s no) t me *or recons derat on. &ost mar'et -art c -ants -robably use a comb nat on o* both *undamental and techn cal analys s1 ) th the em-has s on each sh *t n! as cond t ons chan!eOthat s1 they *orm a !eneral 0 e) about )hether a -art cular currency s o0er0alued or under0alued n a structural or lon!er:term sense1 and ) th n that lon!er:term *rame)or'1 assess the order *lo) and all current econom c *orecasts1 ne)s e0ents1 -ol t cal de0elo-ments1 stat st cal releases1 rumors1 and chan!es n sent ment1 )h le also care*ully study n! the charts and techn cal analys s.

26

-&&icial actions to in&luence e"change rates

2s n some other ma/or ndustr al nat ons ) th *loat n! e%chan!e rate re! mes1 n the An ted States there s cons derable sco-e *or the -lay o* mar'et *orces n determ n n! the dollar e%chan!e rate.,ut also1 as n other countr es1A.S. author t es do ta'e ste-s at t mes to n*luence the e%chan!e rate1 0 a -ol cy measures and d rect nter0ent on n the *ore !n e%chan!e mar'et to buy or sell *ore !n currenc es.2s noted abo0e1 n -ract ce1 all *ore !n e%chan!e mar'et nter0ent on o* the A.S. author t es s rout nely ster l @edOthat s1 the n t al e**ect on A.S. ban' reser0es s o**set by monetary -ol cy act on. Go one <uest ons that monetary -ol cy measures can n*luence the e%chan!e rate by a**ect n! the relat 0e attract 0eness o* a currency and e%-ectat ons o* ts -ros-ects1 althou!h t s d ** cult to * nd a stable and s !n * cant relat onsh - that )ould y eld a -red ctable1 -rec se res-onse. ,ut the <uest on o* the e**ect 0eness o* ster l @ed nter0ent on1 )h ch has been e%tens 0ely stud ed and debated1 s much more contro0ers al. Some econom sts contend that ster l @ed nter0ent on 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%-ectat ons about -ol cy and hel- n! to !u de the mar'et. St ll others bel e0e that the e**ect de-ends on the -art cular mar'et cond t ons and the nter0ent on strate!y o* each s tuat on. + 0en the -resent s @e o* A.S. monetary a!!re!ates1 balance o* -ayments *lo)s1 and the le0els o* act 0 ty n the *ore !n e%chan!e mar'et and other * nanc al mar'ets1 t s ) dely acce-ted that any e**ects o* ster l @ed nter0ent on are l 'ely to be throu!h nd rect channels rather than throu!h d rect m-act on these lar!e a!!re!ates. $m- r cal tests o* ster l @ed nter0ent on ha0e *ocused on t)o ma n channels throu!h )h ch such nter0ent on m !ht nd rectly n*luence the e%chan!e rate3 the -ort*ol o balance channel and the e%-ectat ons1 or s !nal n!1 channel.. .he -ort*ol o balance channel -ostulates that the e%chan!e rate s determ ned by the balance o* su--ly and demand *or a0a lable stoc's o* * nanc al assets held by the -r 0ate sector. 8t holds that ster l @ed nter0ent on ) ll alter the currency com-os t on o* assets a0a lable to the !lobal -r 0ate sector1 and that * dollar and *ore !n currency:denom nated assets are 0 e)ed by n0estors as m-er*ect subst tutes1 ster l @ed nter0ent on ) ll cause mo0ements n the e%chan!e rate to ree<u l brate su--ly and demand *or dollar assets. .he s @e o* th s -ort*ol o balance e**ect )ould 28

de-end on the de!ree o* subst tutab l ty bet)een assets denom nated n d **erent currenc es and on the s @e o* the nter0ent on o-erat on. .he e%-ectat ons1 or s !nal n!1 channel holds that ster l @ed nter0ent on may cause -r 0ate a!ents to chan!e the r e%-ectat ons o* the *uture -ath o* the e%chan!e rate. .hus1 nter0ent on could s !nal n*ormat on about the *uture course o* monetary or other econom c -ol c es1 s !nal n*ormat on about1 or analys s o*1 econom c *undamentals or mar'et trends1 or n*luence e%-ectat ons by a**ect n! techn cal cond t ons such as bubbles and band)a!ons. 2 cons derable number o* stud es ha0e *ound no <uant tat 0ely m-ortant e**ects o* ster l @ed nter0ent on throu!h the -ort*ol o balance channel. Some stud es ha0e *ound e%-ectat ons or s !nal n! e**ects o* 0ary n! de!rees o* s !n * cance. 5thers conclude that the e**ect 0eness de-ends 0ery much on mar'et cond t ons and nter0ent on strate!y. .here are ser ous data and econometr c -roblems n study n! th s <uest on. .o assess success1 the researcher needs to 'no) the ob/ect 0e o* the nter0ent on and other s-ec * c deta lsO)as the a m to amel orate a trend1 sto- a trend1 re0erse a trend1 sho) a -resence1 calm a mar'et1 d scoura!e s-eculat on1 or buy a l ttle t me; .he researcher also needs to 'no) the counter*actual O)hat )ould ha0e ha--ened * the nter0ent on had not ta'en -lace. 2lso1 research on th s ssue must be -laced n the broader conte%t o* research on e%chan!e rate determ nat on1 )h ch noted abo0e1 nd cates that t has not been -oss ble to * nd stable and s !n * cant relat onsh -s bet)een e%chan!e rates and any econom c *undamentals. 2s a -ract cal matter1 t s d ** cult to ma'e s)ee- n! assessments about the success or *a lure o* o** c al nter0ent on o-erat ons. Some nter0ent on o-erat ons ha0e -ro0en resound n!ly success*ul1 )h le others ha0e been d smal *a lures. .he success or *a lure o* nter0ent on s not so much a matter o* stat st cal -robab l ty as t s a matter o* ho) t s used and )hether cond t ons are a--ro-r ate. 8s the ob/ect 0e reasonable; 4oes the mar'et loo' techn cally res-ons 0e; 8s nter0ent on ant c -ated; W ll an o-erat on loo' cred ble; What s the l 'ely e**ect on e%-ectat ons;

29

8n 19831 the Wor' n! +rou- on #ore !n $%chan!e &ar'et 8nter0ent on establ shed at the Lersa lles summ t o* the +rou- o* Se0en )arned a!a nst e%-ect n! too much *rom o** c al nter0ent on1 but concluded that such nter0ent on can be a use*ul and e**ect 0e tool n n*luenc n! e%chan!e rates n the short run1 es-ec ally )hen such o-erat ons are cons stent ) th *undamental econom c -ol c es. An<uest onably1 nter0ent on o-erat ons are more l 'ely to succeed )hen there s a cons stency ) th *undamental econom c -ol c es1 but t may not al)ays be -oss ble to 'no) )hether that cons stency e% sts. 2lthou!h att tudes d **er1 monetary author t es n all o* the ma/or countr es nter0ene n the *ore !n e%chan!e mar'ets at t mes )hen they cons der t use*ul or a--ro-r ate1 and they are l 'ely to cont nue to do so. .he current att tude to)ard *ore !n e%chan!e mar'et nter0ent on s summar @ed n the *ollo) n! e%cer-t *rom the =une 1996 re-ort o* the * nance m n sters o* the +rou- o* Se0en nat ons3

30

1le"ible #7s &i"ed e"change rates

$%chan!e rates stab l ty has al)ays been the ob/ect 0e o* monetary -ol cy o* almost all countr es. $%ce-t dur n! the -er od o* !reat de-ress on and )orld )ar88 1 the e%chan!e rate ha0e been almost stable.dur n! the -ost: )ar 88 -er od 1 the 8&# had brou!ht a ne) -hase o* e%chan!e rate stab l ty. &ost !o0ernments ha0e ma nta ned ad/ustable * %ed e%chan!e rates t ll 1963. ,ut the 8&# system *a led to -ro0 de an ade<uate solut on to three ma/or -roblems caus n! e%chan!e nstab l ty: 1. Fro0 d n! su** c ent reser0es to m t !ate the short term *luctuat ons n the balance o* -ayments )h le ma nta n n! the * %ed e%chan!e arte system. 2. Froblems o* lon! term ad/ustments n the balance o* -ayments. 3. Fr ces !enerated by s-eculat 0e transact ons. #or these reasons the currenc es o* many countr es 1 es-ec ally the reser0e currency )ere sub/ect to *re<uent de0aluat on n the early 19601s. th s ra sed doubts about the -oss b l ty o* the ,retten)ood1s system1and also about the 0 ab l ty 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 ma n ar!uments n *a0our o* * %ed e%chan!e rates are: Firstly1# %ed e%chan!e rate -ro0 des stab l ty n the *ore !n e%chan!e mar'et and certa nty about the *uture course o* the e%chan!e rate and t el m nates r s's caused by uncerta nty due to *luctuat ons n the e%chan!e rates. .he stab l ty o* e%chan!e rate encoura!es nternat onal trade.on the contrary1 *le% ble e%chan!e rate system causes uncerta nty and m !ht also o*ten lead to 0 olent *luctuat ons n nternat onal trade. 2s a result *ore !n trade or ented econom es become sub/ect to se0ere econom c *luctuat ons1 * m-ort elast c t es are less than e%-ort elast c t es. Secondly 1 the * %ed e%chan!e rate system creates cond t ons *or smooth *lo) o* nternat onal ca- tal s m-ly because t ensures a certa n return on the *ore !n n0estment. Wh le n the case o* 31

*le% ble e%chan!e rate1 ca- tal *lo)s are constra ned because o* uncerta n ty about e%-ected rate o* return. Thirdly, the * %ed rate el m nates the -oss b l ty o* s-eculat on1 )hereby t remo0es the dan!ers o* s-eculat 0e act 0 t es n the *ore !n e%chan!e mar'et. 5n the contrary *le% ble e%chan!e rates encoura!e s-eculat on. Fourthly , the * %ed e%chan!e rate system reduces the -oss b l ty o* com-et t 0e de-rec at on o* currenc es as t ha--ened dur n! 1930s. also1 de0 at ons *rom * %ed rate are eas ly ad/ustable. Fifthly1 a case s also made n *a0our o* * %ed e%chan!e rate on the bas s o* e% stence o* currency areas. .he *le% ble e%chan!e rate s sa d to be unsu table bet)een the nat ons )h ch const tute a currency area1 s nce t leads to a chaot c s tuat on and hence ham-ers trade bet)een them. .he ma n ar!uments n *a0our o* *le% ble e%chan!e rates 3 Firstly, *le% ble e%chan!e rate system -ro0 des lar!er de!ree o* autonomy n res-ect o* domest c econom c -ol c es as t s not obl !atory *or the coutr es to tune the r domest c -ol c es to * %ed *ore !n e%chan!e rate. Secondly1 *le% ble e%chan!e rate s sel* ad/ust n! and there*ore t does not de0ol0e on the !o0ernment to ma nta n an ade<uate *ore !n e%chan!e reser0e. Thirdly, the *le% ble e%chan!e rate1 )h ch s determ ned by mar'et *orces1 has a theory beh nd t and has the <ual ty o* -red ctab l ty. Fourthly1 *le% ble e%chan!e rates ser0e as a barometer o* the actual -urchas n! -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 *ormulat on o* the domest c econom c -ol c es.

32

Fifthly, econom sts ha0e also ar!ued that the most ser ous char!e a!a nst *luctuat n! e%chan!e rate .e. uncerat nty s not tenable because s-eculators themsel0es create cond t ons *or e%chan!e rate stab l ty. 2lso1 the de!ree o* uncerta n ty assoc ated ) th *le% ble e%chan!e rate could not be much !reater then )hat the )orld has e%-er enced ) 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 nconclus 0e . n*act1 both systems ha0e the r o)n mer ts and demer ts.

33

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,oo's : &ana!er al $conom cs by 4.G. 4) 0ed . &ana!er al $conom cs by Ehatur0ed . &acroeconom cs by R.H.& sra &acroeconom cs by &.B. Seth S tes C ))).*ore%.com ))).money n0estment.com

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