Foreign exchange - Law and legislation ; Dollar, American

Michael Hutchison

English

Research Papers in Economics

June 10, 1983
What is at issue now, however, is whether
the U.S. should increase the size and fre-
quencyof its intervention operations, and
join Europe and Japan in acoordinated effort
to influence currency values in a more .
systematic fashion.
mentofthe European Monetary System
(june 14, 1982).
Goals of intervention
Among the various arguments put forth
in support ofincreased U.S. intervention
operations, twogeneral policygoals maybe
identified. The first is to moderateshort-term
fluctuations in exchange rates and, in
general, to calm the volatility in exchange
markets. As Chart 1 illustrates, these
week-to-week fluctuations have been large
and erratic in recent years. Proponents of
this view believe thatthe volatility in
.exchange markets disrupts international
trade and capital flows because it increases
exchange rate risk and thereby reduces the
willingness offirms and investors to engage
in international transactions. By smoothing
short-term transitory fluctuations, they
argue, official intervention mightreduce the
risk associated with exchange rate volatility
and help ensure that exchange rate move-
ments reflect underlyingeconomic factors.
The presumption in this view is that foreign
exchange rates reflect "reasonable" or
equilibrium values along atrend, butthat
fluctuations around the trend are caused by
transitory factors and should be reduced.
The intervention strategy often suggested to
counter short-term volatility in exchange
markets is commonly called "leaning
against the wind." Underthis strategy, the
authorities sell foreign currency when it
increases in value and purchase foreign
currency as itdeclines in value. The aim is
to slow, but notreverse, exchange rate
movements in an attemptto reduce overall
volatility. The exchange market sets the
trend ofthe exchange rate path and the
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Underthis strategy, U.5. authorities inter-
vene in foreign exchange markets only
during periods ofextreme market uncer-
tainty. Such periods may be indicated by
rumors ofwar ormajorpolitical change, or
by the partial or full withdrawal ofprivate
institutional participants from the market.
Since early 1981, the U.S. Treasury and
Federal Reserve System have intervened
onlya few times, includingonce on the day
ofthe attempted assassination ofPresident
Reagan (March 30, 1981) and once on
the dayfollowing a major cwrency realign-
Present strategy
TheUnited States presently follows an inter-
vention strategy designed to "counter dis-
orderly markets" when the need arises. This
goal is spelled outexplicitlyunderArticle IV
ofthe International Monetary Fund articles
ofagreement and was emphasized as a
common pointofagreement among the
economic summit participants at last year's
meeting in Versailles, France.
u. S. Intervention Policy
U.5. intervention policycontinues to be
debated in international forums and, most
recently, was an important topic ofdiscus-
sion at the economic summit in Williams-
burg overMemorial Day weekend. The
leaders ofseveral countries, most notably
France, believe that foreign exchange
markets, leftto theirown, are proneto
excessive short-term volatilityand exchange
rate levels not justified byfundamental
economic factors (e.g., prices, income
levels, productivity gains). They see in-
creased U.S. intervention relieving these
problems and lendingstabilitytotheforeign
exchange market.
Should the United States intervene more
often in foreign exchange markets to calm
marketvolatilityoreven tochange the value
ofthe dollaragainst other currencies? Or
should the U.5. maintain its present stance
of intervening only when exchange markets
are clearly "disorderly?"If~cdl~if(m,ll TI«~~~ifW~
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Opinions expressed ill this newsletter do not
necessarilv f'(:-fled the vipws of the management
of the Federal Reservl.' Bank of San francisco,
or of the Board of Covernors of the' Federal
Reserve System.
.authorities attempt to reduce fluctuations
around the trend.
The second policygoal is to maintain
currency values within certain "reason-
able" values (e.g., as determined by their
relative purchasing power), often called
a "target zone:' Proponents ofthis view
believe that exchange rate targeting is
necessary in order to avoid the large
medium-term swings in exchange rates that
the international economy has experienced
in recent years. They argue that large
medium-term swings in exchange rates
disrupt the international economy generally
and are particularly damaging to small,
export-oriented economies.
To the extent that exchange rate swings
diverge from inflation differentials across
countries, the competitive position ofa
countrycomparedto its trading partnerswill
change. As Chart 2 demonstrates, these
"real" exchange rate swings have been
substantial for the u.s. dollar. From a low
in May 1974, for instance, the real rate ap-
preciated more than 12 percentover the
following two years, only to switch course
and depreciate 10 percentduringthe period
1977-78. The dollar began an upward
swing in late 1980 and appreciated over
20 percent by the end of1982.
These swings disrupt production and con-
sumption decisions by shifting relative
prices between exports and imports (and
import-competinggoods), and lead to large
changes in the use ofa country's resources.
The costs to an economy ofmakingthese
changes can often be substantial. Workers,
forexample, havetobe retrained to produce
the new output "mix:' They may suffer
bouts ofunemployment during the transi-
tion. The more /lopen" a country in terms of
the share ofCNP accounted for by exports,
the largerthe disruptive impact these real
exchange rate swings may have on the
economy. European concerns regarding
exchange rate swings may be traced, at least
in part, to their export-oriented economies.
2
(In 1980, the percentageoftotal CNP con-
sisting ofexports was 29 percent in West
Germany, 21 percent in France, and 28 per-
cent in Italy; it was only 10 percent
in the U.s.)
The "target zone" intervention strategy
suggests that central banks should purchase
foreign currency when it depreciates below
the lower bound ofthe target zone, and sell
foreign currency when itmoves above the
upper bound. Such a strategy differs from a
system offixedexchange rate parities in that
it allows the authorities to shift the target
zone in response to changes in fundamental
economic conditions.
The target zone strategy thus presumes that
the authorities are better able to determine
equilibrium exchange rate values than the
market mechanism. Notonly does the stra-
tegy call for countering the fluctuations
around agiven trend, as in the "leaning
against the wind" strategy, it also calls for
determiningthe trend ofexchange rates.
Effectiveness of intervention
The modern theory ofexchange rate deter-
mination suggests that intervention is
probably effective in moderating exchange
rate fluctuations on adailyor weekly basis,
but that itdoesn't have much effect over
longer periods unless countries also adjust
their domestic policies to bring about an
"external" balance. The limited empirical
evidence that is available seems to support
this view. A major international study on
official intervention commissioned after last
year's economic summit in Versailles, for
example, concluded that "intervention can
be useful to counter disorderly markets and
to reduce volatility" but "will normally
be useful only when complementing and
supporting other policies:'
Modern exchange rate theory distinguishes
three basic channels through which official
intervention works: the "flow supply-
demand" channel, the "portfolio balance"
channel and the "signalling" channel. TheChari 2
Real Effective Dollar Exchange Rate
'915 = 1M
125
The industrial countries face a difficuIt
choice. Ontheone hand, central bank inter-
vention seems most effective in curbing
short-term volatility, butthis effectiveness
has little utility because hedging allows
private traders to protectthemselves against
all except the most extreme short-run fluc-
tuations. On the other hand, intervention
operations pursued independently ofother
policy changes have littleeffect on the
medium-term fluctuations that are poten-
tially most damaging to economies.
Concern for the latter problem argues that
the industrial countries should focus on
coordinating their divergent macroeco-
nomic policies.
Michael Hutchison
It is much moredifficulttohedgeagainstthe
risks associated with medium-term move-
ments that reflect "real" exchange rate
changes and shifts in international competi-
tive advantage. Firms engaged in interna-
tional trade, for instance, often complain
aboutthe difficulties posed bythese compe-
titive shifts in making production and mar-
keting decisions. [n sum, undueemphasis
appears to have been placed on short-term
exchange rate volatility and risk when
medium-term fluctuations probably impose
greater real costs on society.
Implications
Both theory and empirical evidence suggest
that official intervention may be effective
when directed toward reducing short-term
exchange rate fluctuations, but not longer-
range values unless they are accompanied
by fundamental policychanges. This is a
serious shortcoming because medium-term
(for example, over one year) swings in ex-
change rates probably have a much greater
adverse economic effect than short-term·
volatility. Moreover, firms and consumers
affected by exchange rate variations can
protectthemselves against short-term
exchange rate uncertainty by hedging their
positions through the forward exchange
market. This hedging involves costs butthe
evidence suggests they are not large,
3
*This analysis assumes that the central bank makes an
offsetting open-market purchase ofdomestic securities to
prevent the intervention from having monetaryeffects.
Intervention may also influenceexchange
rates through a portfolio balance effect. To
supportthe domestic currency, forexampie,
acentral bank may purchase domestic
securities and pay forthe acquisition by
disposing offoreign securities.* From the
private sector's point of view, ithas fewer
domestic securities in its portfolio, and more
foreign currency securities. Investors may
not be indifferent about the mix ofsecurities
in their portfolios. If not, they will try to
restore theirportfolios by buyingdomestic
securities and selling foreign securities. This
shiftofdemand toward domestic securities
at the expense offoreign securities means
acapital inflow to the country, placing
upward pressure on the domestic currency
and causing it to appreciate. The empirical
evidence suggests, however, that this effect
is either small orvariable in magnitude, and
hence difficult to measure. This is not sur-
prising as stocks of securities privately held
are so large that limited intervention opera-
tions wiII only slightly change the compo-
sition of portfolios.
-3
Finally, intervention may affect exchange
rates ifmarket participants believe that it
signals a fundamental change in policy that
would alter the future path ofexchange
rates. This effect, however, lasts onlyas long
as market participants continue to believe
that the "signal" is true, that is, that fun-
damental macroeconomic policies are
changed to bringaboutexternal adjustment.
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CharI 1
Short·Term Volalllily of Trade·Welghted Dollar
P!.'(cenl change
4
first refers to the immediate impact a pur-
chase orsale offoreign currency byacentral
bank has on theexchangerate, as itchanges
the flow supply0 rdemand forthatcurrency.
When the authorities buy foreign currency,
for instance, they increase theflowdemand
forforeign currency and the currency will
have a tendency to rise in value. Oncethe
bank withdraws from exchange operations,
however, flow demand is reduced and the
currency may return to its original value.U018U!4seM' 4eln • UOa~JO • ept'!I~N • 04epl
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BANKING DATA-TWELFTH FEDERAL RESERVE DISTRICT
(Dollar'amounts in millions)
Change from
year ago
Dollar Pe cent
Change
from
5/18/83
Amount
Outstanding
5/25/83
Selected AssetSand Liabilities
Large Commercial Banks
r
Loans (gross, adjusted) and investments* 161,997 - 677 2,660 1.7
loans(gross, adjusted) - total# 140,406 - 539 1,830 1:3
Commercial and industrial 44,264 - 115 599 1.4
Real estate 56,176 29 - 958 - 1.7
loansto individuals 23,550 27 258 1.1
Securities loans 2,697 - 190 844 45.5
U.S. Treasury securities* 7,918 - 80 1,740 28.2
Other securities"' 13,673 - 58 - 910 - 6.2
Demand deposits - total# 39,241 -1,105 2,017 5.4
Demand deposits - adjusted 28,138 86 1,945 7.4
Savings deposits - totaH 66,476 173 36,028 118.3
Time deposits -total# 64,854 - 481 - 30,317 - 31.9
Individuals, part & corp. 58,439 - 207 - 26,866 - 31.5
(Large negotiable CD's) 18,808 - 247 - 16,745 - 47.1
Weekly Averages
of Daily Figures
Weekended
5/25/83
Weekended
5/18/83
Comparable
year~ago period
Member Bank Reserve Position
Excess Reserves (+)/Deficiency (-)
Borrowings
Net free reserves (+)/Net borrowed(-)
106
59
47
101
6
95
97
23
74
* Excludes trading accountsecurities.
# Includes items not shown separately.
t Includes Money Market Deposit Accounts, Super-NOW accounts, and NOW accounts.
Editorial commentsmay beaddressed totheeditor(GregoryTong) ortotheauthor••••Freecopiesof
thisand other Federal Reserve publicationscan beobtained by calling orwriting the Public Informa-
tionSection,Federal,Reserve BankofSan Francisco, P.O. Box 7702, San Francisco94120. Phone (415)
974·2246.

U.S. intervention policy

http://www.frbsf.org/publications/economics/letter/1983/el83-23.pdf

U.S. intervention policy

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