Exchange Rate Mechanisms

Exchange Rate
The rate at which the currency unit of one country may be exchanged for that of another. Exchange rate plays a critical role in country’s level of trade. An exchange rate has two components, the domestic currency and a foreign currency, and can be quoted either directly or indirectly. In direct quotation, the price of a unit of foreign currency is expressed in terms of the domestic currency. Eg: 1 US Dollar = 60.21 INRIn an indirect quotation, the price of a unit of domestic currency is expressed in terms of the foreign currency.Eg: 1 INR = 0.017 USD
Types of exchange rate
Fixed exchange rate: In fixed exchange rate system, the central bank intervenes in currency market in order to keep currency closed to fixed target. It is committed to a single fixed exchange rate and does not allow major fluctuations from this central rate.
Free floating exchange rate: The value of the currency is determined solely by supply and demand in the foreign exchange market. Consequently, trade flows and capital flows are the main factors affecting the exchange rate. Pure free floating exchange rates are rare - most governments at one time or another seek to manage the value of their currency through changes in interest rates and other means of controls.
Pegged exchange rate: A pegged exchange rate system is a hybrid of fixed and floating exchange rate regimes. Typically, with a pegged exchange rate, an initial target exchange rate is set and the actual exchange rate will be allowed to fluctuate in a range around that initial target rate. Also, given changes in economic fundamentals, the target exchange rate may be modified.
How is exchange rate influenced by demand and supply?
Exchange rate can be volatile as demand and supply depends on various factors. Demand: If demand for a currency increases keeping supply constant, the currency appreciates.Supply: Currency depreciates if supply of currency is increased keeping demand constant.Eg : The purchase of Indian cotton by US industries will result in conversion of US dollars to Indian rupee thus increasing demand and appreciating rupee relative to dollar. As rupee gets expensive, demand for cotton decreases thus depreciating the rupee.
Factors affecting exchange rate
Interest Rate: Higher rate of interest makes a country attractive for foreign investors since it provide higher rate of return compared to other countries. This results in exchange rate to rise.
Inflation: A country with a consistently lower inflation rate exhibits a rising currency value, as its purchasing power increases relative to other currencies.
Current Account Deficit: Current Account Deficit shows that a country is borrowing capital to make up for the deficit. This excess demand of foreign currency results in depreciating local currency.
Political and Economical Stability: Foreign investors prefer politically stable and economically sound countries to invest. Such countries would draw investment funds from other countries increasing the demand of local currency which results in appreciating local currency.
Impact of rupee depreciation on Indian economy
Increase in import cost: Depreciation in currency would result in increasing import cost which would result in increase in current account deficit.
High inflation: As seen in 1st point, depreciating rupee causes increase in import cost and if that increased bill is passed to final consumers it lead to higher inflation. So depreciating rupee would either result in increase in current account deficit or inflation.
Fiscal Deficit: The increased bill of crude oil and fertilizer might warrant provision for extra subsidy and government may have to face the brunt of it in form of increasing fiscal deficit.
Sectors such as Auto, cement, capital goods are worst hit by depreciating currency as they either depend on imports directly or are exposed to import of crude oil or fertilizers.
The effect of monetary and fiscal policies on exchange rate
Standard macroeconomic principles indicate that expansionary monetary and fiscal policies increase aggregate demand and output. Expansionary monetary policy affects growth positively by reducing interest rates and thereby increasing investment and consumption spending. Expansionary fiscal policy increases spending, either directly or through lower taxes, and therefore the output is increased in the short term to the medium term. At the same time, expansionary fiscal policy typically exerts upward pressure on the interest rates as larger budget deficits need to be financed.
Expansionary monetary policy leads to capital outflows and thereby downward pressure on the currency. Expansionary fiscal policy should lead to capital inflows and upward pressure on the exchange rate. This mechanism is called the Mundell-Fleming model, developed in the 1960s.
Let us consider four cases involving fixed and floating exchange rates –
Expansionary Monetary Policy with Flexible Exchange Rates: With monetary easing, the interest rates will face a downward pressure. This will in turn induce capital outflow to higher yield markets, putting downward pressure on the domestic currency. The more responsive the capital flows are to the changes in interest rates, the larger the depreciation of the currency. Depreciation of the currency will increase the net exports and reinforce the aggregate demand impact of the expansionary monetary policy.
Expansionary Monetary Policy with Fixed Exchange Rates: To prevent the exchange rate from depreciating, the authority will have to buy its own currency in exchange for other currencies in the foreign exchange market. Doing so will tighten the domestic credit conditions due to lesser supply of the domestic currency and therefore offset the downward pressure due to monetary policy. In the extreme case, expansionary monetary policy will be rendered completely ineffective by the central bank’s purchase of its own currency and the interest rate will be allowed to rise back to its initial level. The monetary authority’s ability to maintain fixed exchange rate will be limited by their foreign exchange reserves. Most developing countries have high levels of foreign exchange reserves.
Expansionary Fiscal Policy with Flexible Exchange Rates: An expansionary fiscal policy will tend to exert an upward pressure on the interest rates which will in turn induce an inflow of capital from lower yield markets putting upward pressure on the domestic currency. If capital flows are highly sensitive to the change in interest rate then the currency will appreciate substantially. On the other hand if the capital flows are insensitive to interest rate changes, then the currency will depreciate rather than appreciate since the increase in aggregate demand worsens the trade balance.
Expansionary Fiscal Policy with Fixed Exchange Rates: To prevent the domestic currency from appreciating, the monetary authority will sell its own currency in the foreign exchange market. The expansion of the domestic money supply will reinforce the aggregate demand impact of the expansionary fiscal policy.
The specific mix of monetary and fiscal policies can have a profound impact on the country’s exchange rate. If the capital mobility is high, a restrictive monetary policy and an expansionary fiscal policy will lead to a highly responsive appreciation of the domestic currency. Thus, this policy is extremely bullish for a currency. Likewise, the combination of expansionary monetary policy and restrictive fiscal policy is extremely bearish for a currency. In case of conflicting policies, the effect on currency is ambiguous. Capital mobility tend to be high in developed countries.
When capital mobility is low (i.e. interest rate changes will not induce any major changes in capital flow), monetary and fiscal policies will primarily affect trade flows and not capital flows. Hence, a uniformly restrictive fiscal and monetary policy will be bullish for a currency because it will tend to an improvement in trade balance. Similarly, a uniformly expansionary fiscal/monetary policy will be bearish for currency as it will lead to a deterioration in trade balance. Combinations of fiscal and monetary policy will have an ambiguous effect on the aggregate demand and thereby on the currency. In emerging market economies, the movement of capital is restricted and hence this case is applicable to developing countries.
The key insights from Mundell-Fleming framework are as follows:
The three objectives – a) independent monetary policies, b) free capital flow across national borders and c) fixed exchange rates – cannot be satisfied at the same time.
The degree of capital mobility is critical to the effectiveness of the monetary and fiscal policy in an open economy.
Policymakers may need to impose capital controls in order to stabilize the exchange rate and make monetary policy a viable policy instrument for domestic objectives such as employment sustainability and price stability.