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INTERNATIONAL ECONOMICS AND FINANCE Exchange Rates Introduction Exchange rate is one of the important measures of economic development of a country. Exchange rate of a country is governed by several factors. Increase in value of local currency makes country’s exports expensive in the global markets which will affect exports…
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Download file to see previous pages... The exchange rate of the local currency comes down due to interplay of demand and supply. The floating exchange rate system based on demand and supply is a self-adjusting mechanism in market economy. But, stability in exchange rate is very important for the growth of the economy. Therefore, the central bank of a country exercises its monetary authority to ensure that the local currency is traded around the desired or target exchange rate. The central bank closely monitors movements of exchange rate of the country’s currency. It will intervene in the market by resorting to open market purchase or sale of currencies to maintain stability or for influencing the exchange rate of the local currency in relation to foreign currencies. Spanjers (2009, p. 10) stated “As the expectation of stable exchange rates tends to promote trade and thus welfare, the monetary authority of each country commits itself to exchange rate targets.” Central bank also in its liquidity management through monetary policies influences money supply in the country with a view to regulate interest rates and keep inflation under control. Money supply in a country will also influence the behaviour of exchange rates. The interest rates and inflation are closely linked to the behaviour of the exchange rate. Gold standard system In Bretton Woods Conference in 1914 the participant countries have agreed to adopt gold standard system which envisaged economic discipline among the nations. But, it could not succeed in achieving the objectives mainly due to currency devaluation spree post-World War-I by the countries to maintain or improve their exports. While devaluation strategy was adopted to make the countries’ products competitive in the world market, in order to make the local products more competitive locally, they also introduced trade restrictions which made the imports costlier. These measures taken by the governments for protecting their national economies had severe impact on the international trade. To stem this tide in international economy, International Monetary Fund was created in Bretton Woods in 1944 with the aim of preserving global monetary order. The exchange rates of the currencies fixed in relation to US Dollar or gold could not work smoothly for a long period. Defending these fixed exchange rates has become increasingly difficult due to several factors. Under the fixed exchange rate regime the country has to continuously monitor the system and impose several restrictions on transactions involving foreign exchange. These restrictions are likely to encourage black market operations in foreign exchange. The question of devaluation of the currency for a country with fragile economy is the greatest cause for concern. The countries’ current account imbalances caused failure of the system because under consistent deficit in current account a currency cannot be kept artificially at a higher exchange rate. Stability in Floating exchange rates and economy The stability factor, being the major concern relating to exchange rates, could not be addressed in floating exchange rate system based on demand and supply for currencies as well. The process of self adjustment expected to come into play is affected by several factors. For example, when a currency becomes weak, the imports become costlier and exports more profitable and the volume of exports is expected to increase. The increased demand for local currency due to exports and ...Download file to see next pagesRead More
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