9.
4 DEALING WITH THE EXCHANGE RATE IN PRACTICE
In practice, the central bank has to deal with the exchange rate at both the macro level and at the
operational level. At the macro level, the central bank would have to be aware of how its policy on the
exchange rate fit with its overall monetary policy framework. The exchange rate, interest rates, and the
inflation rate are inextricably intertwined in the long run, as they all represent various aspects of the
cost of money.
At the operational level, the central bank would have to figure out how, if it wants to do so, to best
influence the exchange rate. The central bank might want to intervene in the foreign exchange market,
or to regulate flows of capital. These actions, however, do have costs that the central bank will need to
consider.
DEALING WITH THE EXCHANGE RATE: THE MACRO CONCEPTS
At the macro level (as opposed to at the operational level), the central bank has to take into account
that the exchange rate, inflation, and interest rates are interrelated. The central bank’s action to
influence one variable could affect the other two variables.
The Relationship between the Exchange Rate, Inflation, and Interest Rates
As is implicit in the various exchange rate theories discussed above, inflation, interest rates, and
the exchange rate are related. The central bank’s action to influence any one of the variables is likely to
affect the other two, at least over the long run (see Figure 9.2).
FIGURE 9.2 The Exchange Rate, Inflation, and Interest Rates Are All Intertwined
For example, other things being equal, a loosened monetary policy stance could raise inflation, according
to the monetary theories discussed in Chapter 5. With higher inflation, according to relative PPP, the
exchange rate of the country with respect to an anchor country would over time depreciate
proportionately in relation to the inflation differential between the two countries. On the other hand,
according to UIP, the loosening of monetary policy that resulted in lower interest rates would also result
in an exchange rate depreciation, other things being equal.
Congruence in the Central Bank’s Actions toward the Three Variables
As the exchange rate, inflation, and interest rates are all intrinsically intertwined, any policy action to
affect one of these three variables will affect not only the variable in question but will also indirectly
affect the other two. Any attempt to move any two pairs of variables in opposing directions will be likely
to prove unsustainable in the long run.
For example, say a central bank wants to hike interest rates to keep inflation down, but at the same time
wants to keep exchange rates weak in order to stimulate exports. Specifically, let’s also say that the
central bank wants to fix the exchange rate at a level it deems favorable to the country’s exports. In such
a case, by raising interest rates to tame inflation but keeping the exchange rates fixed, the central bank
is essentially creating a profit opportunity for investors to bring in foreign capital to invest in that
country (in order to gain from interest differentials), since if the fixing of the exchange rate holds, the
expected depreciation of the currency will be zero.
In other words, in this particular case, the central bank is violating UIP. Such a scheme would be self-
defeating for the central bank, since the higher interest rates will attract more foreign capital, driving up
the demand for domestic currency. However, since the central bank wants to fix the exchange rate, the
central bank will have to intervene in the foreign exchange market by injecting money into the economy
to satisfy the greater demand for domestic currency. The injection of money will, of course, defeat the
initial purpose of the hike in interest rates, that is, the taming of inflation.
At the extreme, if the public realizes at the start that the central bank has both low inflation and fixed
exchange rate objectives, the public might be skeptical about the effect that the hike in the policy
interest rate might have on inflation. Monetary policy and the central bank itself might lose their
credibility. Even without the fixed exchange rate objective, any large scale foreign exchange intervention
without “sterilization” (the central bank’s absorption of liquidity from the system through its selling of
securities to financial market players) could jeopardize the central bank’s price stability objective
credibility.
In theory, the central bank has many options to deal with the exchange rate. At one extreme, it could
focus solely in keeping the exchange rate at a predetermined fixed level through exchange rate
targeting. At another extreme, it could choose to let the exchange rate float freely so that it is
completely determined by market forces (although this is very unlikely in practice). In between these
two extremes, the central bank would choose the degree of exchange flexibility that it deems most
suitable to economic conditions or the central bank’s objectives, or both.
Equilibrium Exchange Rates
When a central bank intervenes to keep exchange rates at a certain level, it is often legitimate to ask if
the central bank thinks such a level is an equilibrium exchange rate for the economy. (Otherwise, why
would the central bank do so?) In a world where information is incomplete and prices are inflexible,
however, determining an equilibrium exchange rate is rather elusive.29
In practice, there have been many definitions of an equilibrium exchange rate. Some of them are (1) the
exchange rate that balances the current account, (2) the fundamental equilibrium exchange rate, (3) the
exchange rate that is consistent with PPP, (4) the exchange rate that equates one’s export prices with
those of the trading partners, and (5) the exchange rate that equates domestic costs to foreign costs.30
As we shall see, these definitions are not exactly congruent among themselves. A level of exchange rate
that seems to suggest equilibrium in one sense does not necessarily suggest equilibrium in
another. Table 9.1 summarizes the pros and cons of these different definitions of equilibrium exchange
rate.
TABLE 9.1 Different Concepts of Equilibrium Rate: Examples and Their Pros and Cons
Source: Adapted from Tony Latter, The Choice of Exchange Rate Regime, Handbooks in Central Banking
No. 2 (London: Centre for Central Banking Studies, Bank of England, 1996).
Exchange Rate That Balances the Current Account
In theory, a sustained
Exchange Exchange Exchange Exchange balanced current account
rate that rate that rate that rate that should imply that the
balances the is equates equates economy has achieved
current consistent export domestic equilibrium with respect to
account with PPP prices with costs to external trade. An exchange
those of foreign costs rate that balances the
trading current account could thus
partners be deemed an equilibrium
exchange rate.
Pros A sustained Popular Theoretically Bypasses the
In practice, however, there
current for reflects the problem of
are at least two reasons that
account comparing equilibrium profit margin
the exchange rate that
balance standards exchange measurement
ensures a balanced current
implies that of living. rate, if that comes
account might not
the economy countries with the
represent an equilibrium
is in have the measure of
exchange rate. First, the
equilibrium. same profit export prices.
feedback loop between the
margin.
exchange rate and the
current account is often
Con Certain Does not Countries do Other uncertain and is subject to
s stages of reflect not have the measurement time lags. The balanced
developmen external same profit problems: current account that we see
t may need a balances. margin for goods are not today does not necessarily
current Not all their identical, correspond to the exchange
account that goods and exports. different rate that we see today.
is not services labor market Second, countries in
balanced. can be structures, different stages of
traded etc. development and
across investment opportunities
border. might need a current
account that is not
balanced, which would result in accompanying structural capital inflows or outflows. For example, a
country that needs foreign investment might be better off having a current account deficit, which would
be financed by capital inflows. On the other hand, a country that does not have enough local productive
investment opportunities might be better off having a current account surplus and invest its surplus
(capital) abroad.31
Fundamental Equilibrium Exchange Rate
The fundamental equilibrium exchange rate can be defined as one that produces the optimal current
account plus normal capital flows.32 This definition allows for the needs of a current account that is not
balanced and structural net capital inflows or outflows. In practice, however, this definition also suffers
from the uncertainty and time lags of the feedback loop between the exchange rate and the current
account (and the accompanying capital flows). Furthermore, it is difficult to determine the optimal level
for the country’s current account and capital flows.
