Federal State Educational Budget Institution of Higher Education
«Finance University under the Government of the Russian Federation».
(Finance University)
International economic relarionship faculty
Department of World Economics and World Finance
Research work
entitled: «Exchange rate policy»
Work is done by
student of ME17-7 group
Klemenov Dmitrii Alekseevich
Проверил
PhD, Fedunin Alexander Sergeevich
Moscow – 2021
Content
Introduction ............................................................................................................... 3
Substance and types of monetary policy ................................................................... 5
Exchange policy ........................................................................................................ 8
Discount policy ....................................................................................................... 10
Conclusion ............................................................................................................... 10
References ............................................................................................................... 14
2
Introduction
Nowadays each country in the world faces the problem of exchange rate
policies. This is quite an important question as it affects all country’s relations with
foreign counterparties, from business to the government itself. It is impossible to
imagine a country that do not encounter the need to deal with foreign producers,
customers, etc. or even government bodies, as international credit loans do exist. So,
it is obvious setting exchange rate policies is important enough not to underestimate
it. Of course, there is an opportunity to delegate this to market mechanisms, but
nevertheless a government should set at least basic policies to prevent a sudden
collapse of the national economy. From this point of view, this work is relevant and
topical these days and it will, no sooner than a common currency for all countries is
introduced.
Exchange rate policy is the part of macroeconomic regulation and this means,
that it may affect main economic indicators in the country. The globalization has
made countries quite dependent on each other. These days they are connected to
each other so tight, that a financial crisis started only in one country (e.g. the USA)
may become an international one, as it happened in 2008. Since this, the government
should be considered about providing their citizens adequate level of defense against
financial problems coming from outside the country.
The purpose of this research work is to define the importance of exchange rate
policies and making conclusions about its role in the society. To reach this goal a set
of objectives was established: to analyze substance and types of exchange rate policy
to get acknowledged the main mechanisms of it;
3
The object of this work is global financial system and the subject are exchange
rate policies of different countries, that together establish the main guidelines of
world financial system.
The research is based on Russian and foreign articles and researches in the
sphere of exchange rate policies, statistical data of Central Bank of Russian
Federation, reports of international organisations like International Monetary Fund,
World Bank, etc. and business information and analytical systems like Bloomberg
professional.
4
Substance and types of monetary policy
Without a doubt it can be stated that almost all countries in the world are
involved in global economy. So, this is vital for them to establish their own exchange
rate policies. But what does this term stand for? It can be best described as set of
regulatory rules at the financial markets that should be obeyed by all participants1.
First of all, exchange rate policy includes a government decision about its
exchange rate system that would be introduced and particular terms and conditions
about exchange rate of national currency, such as limits, in case of setting floating
exchange rate (that would be described later in this work).
The government also sets the rules that allows it to affect exchange rate by
using market mechanisms or, vice versa, to keep it fixed.
In other words, the government has a significant number of aspects to be
regulated, so it has a great influence that is used to keep the national economy sane
and stable.
Of course, it is not enough just to set rules, the government should always
keep an eye on current foreign exchange market to prevent issues, that may damage
the wellbeing of the citizens. Exchange rate policy influence relative price structure
in the national economy between goods that exist on international markets (in other
words, imported) and the ones that are produced domestically. What is more,
exchange rate also has a significant influence on the overall level of prices in a
country, as quite a lot of goods and raw materials are imported or exported, since we
live in the century of blossoming globalization2.
So, let us discuss exchange rate policy in greater details, as we have
determined main points of this term itself.
1
2
Borisov E.F. Economic theory / 2015, p. 396.
Exchange rate policy. Economics Online – science portal for students of economics. Retrieved from:
https://www.economicsonline.co.uk/Managing_the_economy/Exchange_rate_policy.html (accessed at 16.03.2021).
5
There are 2 main types of exchange rate regimes: floating and fixed ones.
Also, a semi-floating regime is used by some countries as a viable solution to keep
the national economy running normally. All of them are going to be discussed. Let
us start from the floating one.
Floating exchange rate can be best described as a situation, when government,
on behalf of the central bank of a certain country, gives its right to impose the
exchange rate of the national currency to the FOREX (foreign exchange market).
Stated another way, government gives up the control to market mechanisms. There
are a lot of currencies that have a floating exchange rate – for example, the US dollar
and about 40% of other currencies in the world3.
This regime is quite advantageous for the government, as it allows not to
spend its limited resources to sustain stable exchange rate of a national currency and
reduce costs for government bodies controlling the exchange rate. But at the same
time there is a significant disadvantage of this regime. The exchange rate becomes
highly volatile. In other words, the value of national currency may sharply decline
and then rise dozens of times each day.
Though, this may be insignificant for such currencies like the US dollar, as it
is still not under a risk, because of the status of world’s top-1 currency. But for big
number of currencies such high volatility may be harmful for their economies.
That is why some countries use semi-floating (or it can also be called semifixed) exchange rate regime. But let us discuss fixed exchange rate regime first, to
get better the idea of semi-floating one.
Before 1944, values of currencies were pegged to gold standard. But in 1944,
countries decided to replace gold for the US dollar, as one of the most stable
currencies at that moment. That is how ended the history of the gold standard. So
far, currencies are still pegged to the US dollar, as it has become a reserve currency
of the global economy.
3
Exchange-Rate Policies. Lumen learning - open educational resource for students. Retrieved from:
https://courses.lumenlearning.com/wm-macroeconomics/chapter/exchange-rate-policies/ (accessed at 16.03.2021).
6
But let us return to fixed exchange rate regime. It sets the constant value of a
national currency, so you always know the exchange rate of your domestic currency.
In other words, the sum spent on purchasing a certain sum of the same foreign
currency will always remain unchanged.
This grants the stability of a national currency, as national central banks
monitor and control its price at foreign exchange markets. The great advantage of
this stability is that foreign investors are always confident, that their business will
not be affected by exchange rate fluctuations. It gives them freedom from constant
concerns about exchange rate risks.
Also it provides an opportunity to reduce inflation, if the government pegs
currency to the reserve currencies or just stable ones (e.g. the US dollar, Euro, etc.).
As soon as the USA and the European Union are growing steadily these days (except
2020 year with the decline caused by Covid-19 pandemic), a national economy,
which currency is pegged to the US dollar will have the same rate of inflation as the
United States of America. Of course, it is true in case the American economy is
doing well. Otherwise, it may cause even higher inflation, than it could occur with
floating exchange rate regime.
Another problem of the fixed exchange rate is that costs for maintaining it can
be incredibly high. A country should have significant foreign exchange reserves in
disposal, to prevent fluctuations of its national currency. It becomes even more
expensive when speculators are beginning to play against this currency.
The actions of profiteers may even force the government to refuse to use fixed
exchange rate regime, because of insufficient funds to maintain it. For example, in
1992 G. Soros shorted the British pound for so long time that the government of the
UK had no other choice than give up fixed exchange rate and let the British pound
to become floating currency4.
4
Miclashevskaya N.A., Sidorovich A.V. Global economy. Publishing company Entrepreneurship and services. 2016,
p. 272.
7
But let us return to semi-floating exchange rate regime5. It provides the
benefits of both regimes, that were discussed above, reducing their negative effects.
It can be explained as fixed exchange rate, but instead of one fixed value the central
banks defines the limits of the exchange rate of a national currency. Thus, if it
plummets are grows beyond the limits, the central bank adjusts it with the
mechanisms same to fixed rate regime ones. In other words, it is far more
advantageous than fixed exchange rate regime or the floating one.
First of all, it is easier to fight against speculators, trying to damage the
national economy for their own benefit. Also, the price level and inflation issues
benefit from regime, close to fixed. Foreign investors are less worried to, that do not
significantly decrease the level of foreign direct investment (FDI) in the economy
and, thus, the economic growth does not suffer from the lack of investment6.
But it also provides advantages of floating exchange rate regime. It is less
expensive to maintain, as the costs are reduced, because of a higher range of
acceptable values of a national currency exchange rate.
To better understand the principles of national central banks influencing
exchange rate, we will look at foreign exchange policy and discount policy.
Foreign exchange policy
A part of exchange rate policy that is aimed to control the value of a domestic
currency at FOREX is called a foreign exchange policy. It regulates to main issues
of exchange rate policy:
1. Setting an exchange rate regime for a national currency;
5
Exchange rate regime of the Bank of Russia. Official website of the Central Bank of Russian Federation. 20.03.2020.
Retrieved from: https://courses.lumenlearning.com/wm-macroeconomics/chapter/exchange-rate-policies/ (accessed
at 16.03.2021).
6
Jefferis K. Exchange Rate Policy and Monetary Policy Implementation. International Growth Centre - International
Conference on Monetary Policy Frameworks in Developing Countries. 2014, p. 12.
8
2. Regulating it with various instruments that are as follows: foreign exchange
intervention; devaluation and revaluation; currency restrictions.
The most important instrument of the government's monetary policy is foreign
exchange intervention. This mechanism allows the central bank to influence the
exchange rate of a domestic currency mainly through the purchase (or sale vice
versa) of foreign currency from its reserves to maintain fixed value of the national
one7.
Foreign exchange operations are supposed to alter the degree of the
underlying exchange rate or the aspirations of foreign exchange market participants.
The operation of the mechanism of foreign exchange interventions is similar to the
conduct of commodity interventions. The main idea is that the central bank sells its
assets and purchases a national currency in order to increase the demand of it and,
thus, its value. Reverse action also take place if a national currency becomes
overvalued. This action is quite often conducted at a large scale and relatively short
period of application.
As a rule, mostly foreign currencies reserves are employed for interventions.
The condition of a domestic currency can be calculated keeping in mind the
massivenes of this intervention.
Authorized operations may be conducted in a variety of forms, whether on
stock markets (explicitly) as well as on the interbank market (secretly), through
traders and brokers or directly by making transactions with credit institutions
themselves, for a set period of time or immediately8.
Furthermore, government foreign exchange interventions may be classified as
«sterile» or «non-sterile». «Sterile» refers to interventions in the course of which
changes in official foreign net assets are offset by corresponding changes in domestic
assets. In other words, there is almost zero impact on the scale of the formal "money
supply. In case the adjustment to government foreign currency reserves after the
7
Steinberg D., Walter S. Handbook of Safeguarding Global Financial Stability. 2013, p. 523.
8
Terra C. Principles of International Finance and Open Economy Macroeconomics. 2015, p. 227.
9
intervention causes a change in money supply, the intervention is considered
«unsterile».
Exchange rate interventions must have the following conditions to generate
the required outcomes of adjusting the value of a domestic currency in the long
period:
1. The possession of the sum of assets needed by the Central bank to carry out
foreign exchange intervention.
2. Economic agents' confidence in the central bank's long-term policy9.
Thereby, exchange rate intervention means the action the Central bank's
buying or selling foreign currency. The volume is defined by of the trade balance
and cumulative foreign currency reserves. With a continuous balance-of-payments
deficit provoked by the nation's loss of competitiveness in the global economy,
reserve assets deteriorate to a critical level. It becomes impossible to correct the
negative balance of payments through interventions. In this case, the central bank
announces a devaluation in the country or sets floating exchange rate regime.
Discount policy
The change of interest rate by the Central bank of a country may serve to
control the value of a domestic currency at foreign exchange markets; the amount of
loans, provided to citizens and domestic companies; money supply and also inflation
level and aggregate demand - this is usually referred as a discount policy10.
A nation's trade balance is the difference between nominal transfers coming
into the country from overseas and all transfers abroad within a given time span.
9
Yeyati L.E., Sturzenegger F. Handbook of Development Economics. Vol. 5, 2010, p. 4281.
10
Onyiriuba L. Bank Risk Management in Developing Economies. 2016, p. 637.
10
Any of the country's international economic activities are counted in the
balance of payments. The balance of trade is measured in the manner proposed by
the International Monetary Fund in the majority of countries worldwide11.
The following should be distinguished: foreign trade balance, balance of
services and non-commercial payments, balance of capital and credit flows. At the
same time, an active balance of payments is a balance in which receipts exceed
payments. The surplus of the balance of payments contributes to enforce the
country's position in the global economy. Passive balance of payments - a balance
in which payments exceed receipts. The usual passive balance of payments is
covered through the use of its foreign currencies reserves or through foreign loans
and credits or capital imports.
For example, with a passive balance of payments in conditions of relatively
free movement of capital, an increase in the discount rate can stimulate the inflow
of capital from countries with a lower interest rate and restrain the outflow of
national capital, which contributes to an improvement in the balance of payments
situation and an appreciation of the exchange rate. By lowering the official rate, the
central bank is counting on an outflow of domestic and foreign capital in order to
reduce the balance of payments surplus and depreciate its currency.
Regulation of foreign capital movements often reduces the effect of strategies
connected to the balance of payments. As a result, the discount scheme has a short
period and is rather inefficient. Credit restriction policy (expensive money) is used,
as a rule, in conditions of a rapid industrial boom and growth of economic activity.
Its goal is to suspend the process of active use of credit by business entities and an
industrial boom, which often leads to overheating of the national economy.
The strategy of «cheap money» is aimed at stimulating credit operations in the
expectation that more attractive credit conditions will contribute to economic
activity, production growth and attraction of foreign capital.
11
McKinnon R.I. Monetary and Exchange Rate Policies for International Financial Stability: A Proposal. Journal of
Economic Perspectives. 1988; 2 (1): pp. 83-103.
11
In modern conditions, the effectiveness of the discount policy decreases due
to the contradiction between foreign economic and domestic economic goals. An
increase in the discount rate negatively affects the economy, which is in a state of
stagnation. This is a rather short-term measure.
12
Conclusion
Exchange rate policy serves to provide the country's internal economic
stability and safety, lead to faster development of its economy by increasing relations
with other countries and establish opportunities for the state's economy to be fully
integrated into the global economic system.
Market and government regulation of currency relations occurs in parallel.
Market stability is based on the operation of the law on the ratio of supply and
demand of currencies in the currency market. And this, in turn, significantly affects
the establishment of their exchange rate ratio.
A central bank chooses the regime of a domestic currency, floating or fixed
ones. The fixed one provides the highest level of stability for a national economy, as
all economic agents can be confident in exchange rates and have no needs to worry
about exchange rate risks. Thus, it is very expensive to maintain, so semi-floating
exchange rate regime provides similar opportunities with less costs. At the same
time, a central bank may give up control against the value of a domestic currency at
FOREX. This is cheap to maintain, but highly risky, as significant fluctuations and
declines in the exchange rate of a national currency may seriously damage the
national economy.
The Central Bank of Russian Federation plays a vital role in exchange rate
issues via controlling interbank agreements and representing the government's
priorities in connection with central banks of other countries, foreign banks, and
other credit and financial entities.
The Central Bank of Russian Federation as any other national banks of other
countries have main functions as follows: performing foreign exchange transactions,
aimed to affect the exchange rate of a domestic currency; establishing the sphere and
mechanisms of
distribution
of
foreign
currency
and
securities
in
the
country; publishing law restrictions in the sphere of foreign exchange; controlling
the domestic currency exchange rate against other countries' currencies, and issuing
licenses to banks to perform foreign exchange transactions.
13
References
1.
Borisov E.F. Economic theory / 2015, p. 396.
2.
Canto V.A., Wiese A. Economic Disturbances and Equilibrium in an Integrated
Global Economy. 2008, p. 419.
3.
Exchange rate policy. Economics Online – science portal for students of
economics.
Retrieved
from:
https://www.economicsonline.co.uk/Managing_the_economy/Exchange_rate_
policy.html (accessed at 16.03.2021).
4.
Exchange rate regime of the Bank of Russia. Official website of the Central
Bank
of
Russian
Federation.
20.03.2020.
Retrieved
from:
https://courses.lumenlearning.com/wm-macroeconomics/chapter/exchangerate-policies/ (accessed at 16.03.2021).
5.
Exchange-Rate Policies. Lumen learning - open educational resource for
students.
Retrieved
from:
https://courses.lumenlearning.com/wm-
macroeconomics/chapter/exchange-rate-policies/ (accessed at 16.03.2021).
6.
Jefferis K. Exchange Rate Policy and Monetary Policy Implementation.
International Growth Centre - International Conference on Monetary Policy
Frameworks in Developing Countries. 2014, p. 12.
7.
McKinnon R.I. Monetary and Exchange Rate Policies for International
Financial Stability: A Proposal. Journal of Economic Perspectives. 1988; 2 (1):
pp. 83-103.
8.
Miclashevskaya N.A., Sidorovich A.V. Global economy. Publishing company
Entrepreneurship and services. 2016, p. 272.
9.
Official website of the Central Bank of Russian Federation. Retrieved from:
https://www.cbr.ru/ (accessed at: 16.03.2021).
10. Onder Y.K., Villamizar-Villegas M. The Effects of Monetary and Exchange
Rate Policy Shocks: Evidence from an Emerging Market Economy.
International Journal of Central Banking. 2018; 52: p. 159-199.
14
11. Onyiriuba L. Bank Risk Management in Developing Economies. 2016, p. 637.
12. Steinberg D., Walter S. Handbook of Safeguarding Global Financial Stability.
2013, p. 523.
13. Terra C. Principles of International Finance and Open Economy
Macroeconomics. 2015, p. 227.
15