exchange market. Trading transactions associated with the export/import of goods and services and capital account flows determine the external values of currencies in relation to one another. The market establishes an equilibrium or natural exchange rate without any political decision or interference.
A floating exchange rate regime can also take the form of
managedffoat
(also calleddirty float)
if the central bank occasionally intervenes in the foreign exchange market to buy or sell its own currency in order to prevent it from excessively appreciating or depreciating. Moreover, in this type of float, official financing and/or interest rate policy are also used in order to influence the exchange rate at certain points of time to ensure it is consistent with domestic economic objectives.Advantages of Exchange Rate Targeting
The most important advantage of exchange rate targeting is its con:r^' over imported inflation. In particular, developing countries with he reliance on the import of capital goods and raw materials immedia face high inflation when the value of their currency depreciates in foreign exchange market. In this case, the central bank can use the. of exchange rate to control the extent of inflationary pressure cor from costly imports. In emerging or developing countries wl institutional capacities are not as strong as in developed economies j where duration of business cycles is short (e.g. quick spells of inflation), exchange rate targeting can be used effectii
Moreover, like inflation targeting, an exchange rate target has the ac of clarity and simplicity. Financial market participants, as wel : general public, can easily understand what it means for their oj if a central bank announces an exchange rate target.
Disadvantages of One clear disadvantage of exchange rate targeting is that when ‘A’ ties Exchange Rate its currency to Country B , eamric shocks in Country transmit to Country Targetmg A • Therefore, the monetary policy of ( loses its ability to respond to
domestic shocks that are indef those hitting Country t, . Another problem with exchange rate I particularly with a fixed exchange rate, is that the country: foreign exchange reserves to support its depreciating currency, 'w this situation is very tough in practice for a country and foreign exchange reserve position of most central banks ~ speculators5
paradise as a bet against a country’ s currency huge profits if devaluation occurs. If enough speculators scD i “snot, , , feywill tend to validate their devaluation expectat disparities due to differing country wage bargaining systei misaligned exchange rates. Technological advances ani resulted in structural changes in economies with
effects on export and import values. Economies also experienced differing economic growth rates which affected per capita income levels and resulted m changing consumer preferences for domestic and imported goods and services. The rise of new industrial and emerging economies has also shifted the shares and pattern of world trade. All these factors and others resulted in overvalued and undervalued exchange rates at regular intervals, forcing the abandonment of the fixed exchange rate system by an increasing number of countries.
How are they inter-connected?
Exchange rate targeting also influences interest rates. To understand this more easily, consider a simple example. Suppose SBP is following a fixed exchange rate regime whereby PKR is tied to USD. In order to maintain a fixed exchange rate, say PKR 60 against every USD, SBP has a large quantity of USD reserves that it sells (buys) in the foreign exchange market when PKR depreciates (appreciates) too much. Now let’ s assume that, since PKR looks set to depreciate to PKR 61 per USD, SBP sells some of its USD reserves in the foreign exchange market in order to keep PKR from depreciating. However, selling USD means contracting money supply from the interbank market (i.e. buying PKR), which ultimately leads to
•iooetary Policy Regimes 187
tighter liquidity in the market and an increase in market interest rates.
Interest Rate and Exchange Rate,
Moreover, recall from Chapter 10 that central banks can adjust their key policy rate to influence exchange rate. Often central banks take on multiple policy roles whereby they change policy interest rates on the one hand and buy/sell domestic currency in the foreign exchange market on the other, while keeping the ultimate target in sight - inflation or price level (see Box 11.1 for the UK’ s experience with interest rate adjustment under exchange rate targeting). Nevertheless, it is not necessary that central bank simultaneously communicate inflation and exchange rate targets.
Chart 11.1: New Zealand CPI Inflation (ye ar-on-year change)
%
j Startof BollalkMi fFTargsBit-
Source: Reserve Bank of New Zealand
Another important thing to note is that a government can fix either interest rate or exchange rate, but not both together. A fixed exchange rate will require interest rates to be flexible in order to control capital inflows/outflows and domestic economic activity.
Monetary Policy in an Open Economy with Flexible Exch ange Rate
Conduct of One analysis of monetary policy conduct is based upon the Mundell- Fleming model
Monetary Policy in (named after economists Robert Mundell and Marcus Fleming). The Mundel-Fleming an open economy model is an extension of the IS-LM framework IS (Investment-Saving relationship) refers to the equilibrium in goods market while LM (Money Demand-Money Supply relationship) refers to the money market equilibrium. IS-LM framework is used to study the relationship between interest rate and real output in goods and money markets. The intersection of IS and LM curves is often called General Equilibrium, i.e. a state when both goods and money markets are in equilibrium simultaneously with an open economy. In this section, we will analyze how monetary policy adjustments affect interest rates and aggregate output in a small open economy. For the following discussion, help is mainly taken from Macro Economics, Rudiger Dornbusch and Stanely Fischer, Macgraw-Hill International Editions, 1990.
Consider chart 11.2 that plots familiar IS-LM curves Standard text books on monetary economics introduce another curve on this graph - Balance of Payment curve (refer to Monetary Economics: Policy and its Theoretical Basis, Keith Bain and Peter Howells, Palgrave Macmillan, 2003). We have omitted this curve for the sake of simplicity.. Point Eo is our starting point where goods and money markets are in equilibrium. Moreover. 2: this point, domestic interest rate id equals foreign interest rate if. New assume that the central bank increases nominal money supply, which I at a given price level, leads to the increase in real money balances RNL j Increase in RM pushes the LM curve rightward from LM1 to LM2. NfWj equilibrium is at El where goods and money markets are in equilibr
Chart 11.2: Effects of Monetary Policy in Floating Exchange Rate R^ime Interest
A
7
IS (Investment-Saving relationship) refers to the equilibrium in while LM (Money Demand- Money Supply relationship) refers 1 market equilibrium. IS-LM framework is used to study the between interest rate and real output in goods and mone> intersection of IS and LM curves is often called General Equilib when both goods and money markets are in equilibrium 8For the following discussion, help is mainly taken from Rudiger Dornbusch and Stanely Fischer, Macgraw-Hill Intc 1990.
Standard text books on monetary economics introduce ar graph - Balance of Payment curve (refer to, for example,
Policy and its Theoretical Basis , Keith Bain and Peter Macmillan, 2003). We have omitted this curve for the
189 -^-*cs and Monetary Policy Regimes
Monetary Policy in an Open Economy with Fsxed Exchange
Rate
foreign mter ; st it , 'd — COme down below and will cause exchange rate ho : WI^°W °Ut ofthe country -change rate depredftln
w*makeT H * The
more competitive and thus outm]t in 0mestlc country’s exports from ISi to IS2 and
exchange keeps & IS Curve shfs
of domestic goods falls
cZ^tn
PT *
*rdatlve £[fe Now, at E2, we have gLs to E,depreciation does not always lead tn ^.mstance, exchange rate domestic economy is highly im non A lmfOVed extsmaI account if the in the case ofa • Moreover,
rates alone cannot induce foreL caniLl a 7> £11 [ MSS^in --- n^n into account
other C= S* a f"1^ Nestor also market risk premium. mcludmg sovereign rating and
Crease its foreign exchange re*esTt —Cy, aso has *
equilibrium from EH to E2 in CharUl 2°h A : shft of—sells foreign
currency in the market'to SmCeJhe Central bank
ultimately, the equilibrium returns to F 1,exchange ® intact, in output. £tUrnS ° El
Wlth 0I
% a short-lived increase
M°netafy po,ky and the ro,e
4; m State Bank of Pakistan (SBP)
- — = — - tn
"'stfb* Policy in
instrument to signal contractiomn, n count Rate as the key
1997, SEP s central board was empowered—-* POlky.In independent monetary policy and at thA conductand
implement an Fiscal Coordination Board was set un to fefflfrrr a^p, k Monetary and remained in line with those taken hv
fiscal ^oIic . ♦ - , - '/
Vlrlitinn 9RP
P y actions -worked extensively to improve was necessary because the financial 1t re^piatms,
which
Over the years, SBP has also improved monetary policy communicatxo with the release of detailed policy statements and supporting datAAft the mid 1990s, the quality of SBP publications has improved both m terms of coverage and depth. SBP ’ s Research Bulletin, the early 2000s, also provides academicians, as well as S # □
with a platform to express their independent views and to bring contemporary economic issues into the limelight.
Today, SBP follows a monetary policy regime that focuses on monetary targeting (with broad money - M2 - as anchor) m accordance with th targets of inflation and real GDP growth envisaged by *e governmeAA of Pakistan - recall from the preceding discussion that Ganges level ofmoney supply have significant impact over both level in the economy. SBP signals a monetary policy stance pnm through changes in the Discount Rate (also called reverse repo mteA addition SBP may also adjust the Cash Reserve Requirement (CRR) ar: the Statutory Liquidity Requirement (SLR) to complement rts moneta.:
policy stance.
In order to understand the SBP ’ s monetary policy stance, it is to understand what makes up money supply. From the asse s i - - money equals net foreign assets (NFA) and net domestic assets (ND X ^ the banking system.
M2 = N F A +
More specifically, NFA is the difference between foreign exchange i and outflows arising from foreign trade, foreign investment
and m
debt-related activities. Conversely, NFA reflects Pakistan s payment position. On the other hand, NDA consists of domeA a to the private sector and government. In order to undersun- monetary policy is conducted and what trade-offs SBP canAA a simple example. Suppose that, due to some exogenous de-.,A outside the control of SBP, PKR depredates against UbD . a g deterioration in the balance of payments. This will tngger --- ^ and M2 growth will fall below what SBPhas been targets cannot directly influence the exchange rate (Pakistan regime is Floating.), one way of achieving the targeted V- reduce the Discount Rate, which will increase credit NDA. However, such a policy can also initiate a vxi L L: —- interest rates can also bring about domestic currency der* to such
inter-linkages, SBP considers development 0 economic variables ranging from international
conur
Agovernment’s tax collection, and from private sector growth in sub-sectors of the economy, before formula
policy.
Since 2005, in response to increasing inflation, SBP has adopted a contractionary SBP s recent monetary policy stance (see Chart 11.3). Before 2005, monetary policy was relatively
monetary polfcy easy, which ensured availability of cheap credit. This led to increasing demand pressures expenence
and inflation started rising. SBP responded to this demand-pull infl ation by increasing the
Discount Rate in 2005.2008 was the year when on the one hand global commodity prices started escalating and on the other, government started borrowing excessively from SBP. These developments not only triggered cost-push inflation but also fueled demand-pull inflationary pressures. As a result, inflation abruptly rose to levels never seen in decades. Monetary policy was further tightened and the Discount Rate was increased from 9% in July 2007 to 15% in November 2008. Some easing in monetary policy was seen after a cool-down in inflation that started in January 2009 and continued till October 2009. Nevertheless, a second phase of contractionary monetary policy started in September 2010 and has continued to this date. Whether the SBP, s stance was more reactive than proactive is still a hot topic in academic debates
Chart 11.3: Inflation and SBP's Monetary Policy Response