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Chapter Five Government Policies toward the Foreign Exchange Market Instructor: Aijing Song Outline Glossary Two aspects: rate flexibility and restrictions on use Floating Exchange Rate Fixed Exchange Rate Defense through official intervention Exchange control Glossary Clean float Fixed/pegged Adjustable peg Crawling peg Parallel market Two aspects: rate flexibility and restrictions on use rate flexibility restrictions on use - also called exchange controls, which may be broad-based or may be applied only to some types of transactions (e.g., capital controls). Floating Exchange Rate In the polar case of a clean float the government permits private market demand and supply to set the exchange rate with no direct involvement by government officials. In a managed float or dirty float the government officials do intervene at times to try to influence the exchange rate, which otherwise is driven by private demand and supply. Fixed Exchange Rate what to fix to? - include gold (or some other commodity), the U.S. dollar or some other single currency, or a basket of currencies. When to change the fixed rate? - we often then speak of a pegged exchange rate instead of a fixed exchange rate - The choice of when to change the peg is closely related to how wide is the band around the central or par value chosen for the fix. Fixed Exchange Rate Defending a fixed exchange rate - official intervention in which the government buys and sells currencies; - exchange controls, in which the government tries to suppress excess demand or supply; - altering domestic interest rates to influence short- term international capital flows; - adjusting the country's macroeconomic position to make it fit the fixed exchange rate. Defense through official intervention Defense through official intervention - Defending against depreciation 1) entering the foreign exchange market to buy domestic currency and sell foreign currency. - Defending against appreciation 1) the directions reversed compared with the abovementioned points Defense through official intervention - Temporary disequilibrium 1) If the imbalance in the country's official settlements balance is temporary, then official intervention that smoothes the time path of the exchange rate can enhance the country's economic well-being - Disequilibrium that is not temporary 1) intervention alone not likely to be able to sustain the fixed exchange rate. 2) the government must shift to one of the other defenses or devalue; 3) not easy for officials to judge whether a payments imbalance is temporary or fundamental. Exchange Control Introduction of Exchange Control - used by many countries, especially developing countries. - cause economic inefficiency analogous to quantitative limits (quotas) on imports. - incur substantial administrative costs. - Efforts to evade them lead to bribery and parallel markets.
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