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Government Policies toward the Foreign Exchange Market

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1 Government Policies toward the Foreign Exchange Market
Session 20 Government Policies toward the Foreign Exchange Market

2 Two Aspects :Rate Flexibility & Restrictions on Use
1.Those policy that are directly apply to the exchange rate itself In the simplest terms, government choose between floating and fixed exchange rate. 2.Those policy that directly state who may used the foreign exchange market Permits use of the foreign exchange market for all payments for export and imports of goods and services . Imposes some form of capital controls, by placing limits or requiring approvals for payments related to some (or all) international financial activities.

3 Floating Exchange Rate
1) Clean Float The clean float is the polar case of complete flexibility. 2) Dirty Float Managed Float The monetary authority enters the foreign market to buy or sell currency (in exchange for domestic currency) so as to alter the configuration of supply and demand, and thus influence the equilibrium value of the exchange rate. Often the government is attempting to lean against the wind to moderate movements in the floating rate.

4 Fixed Exchange Rate The way that the government chooses the policy of a fixed exchange rate that it want. Often, some flexibility is permitted within in a range, call a “band”. The government faces three specific major questions : To what does the government fix the value of its currency ? When or how often does the country change the value of its fixed rate ? How does the government defend the fixed value against any market pressures pushing toward some other exchange rate value ?

5 What to Fix To ? 1. Gold 2. Other currency
3. Average value of a number of other currencies 4. Special drawing right (SRD) the SRD is a reserve asset created by the International Monetary Fund (IMF). The IMF periodically adjusts the specific composition if the SDR. For example, one SDR equals the collection of U.S. $0.577 plus Euros plus 21 Japanese yen plus £

6 When to Change the Fixed Rate ?
Pegged exchange rate 1.Adjustable peg The peg value is not changed often. The government try to keep the value fixed for long periods of time. Nonetheless, in face of substantial or disequilibrium in the country’s international position, the government may change the pegged-rate value. 2.Crawling peg The peg value is changed often (for instance, monthly) according to a set of indicators or according to the judgment of the government monetary authority. Some indicators could be the inflation rate, official reserve assets, the growth of the country's money supply and so forth.

7 Defending a Fixed Exchange Rate
Five basic ways for the government The government can intervene in the foreign exchange market, buying or selling foreign currency in exchange for domestic currency, to maintain or influence the actual rate in the market. The government can impose some form of exchange control to maintain or influence the exchange rate by constricting demand or supply in the market. (Closely related approach would use trade controls such as tariffs or quotas to attempt to accomplish this result.) The government can alter domestic interest rate to influence short-term capital flows, thus maintaining or influencing the exchange rate by shifting the supply – demand position in the market.

8 The government can adjust the country’s whole macroeconomic position to make it fit the chosen fixed rate value. Macroeconomics adjustments driven by the changes in fiscal or momentary policy can alter the supply-demand position in the foreign exchange market, for instance, by adjusting export capability, the demand for import or international capital flows. The government can alter its fixed rate (devaluing or revaluing its currency) or switch to a floating exchange rate.

9 Defending against Depreciation
New Spot Rate S1$ D$ Dollars need to be sold Excess Demand

10 Defending against Appreciation
Dollars need to be bought Excess Supply S1$ New Spot Rate D$

11 Temporary Disequilibrium
S2£ (Low Season) S1£ S3£ (High Season)

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