the ditermination of exchange rate (assignment)

8/7/2019 The Ditermination of Exchange Rate (Assignment)

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[ T y p e t h e c o m p a n y

n a m e ] In simple terms, it is the interaction of supplyand demand factors for two currencies in themarket that determines the rate at which theytrade. But what factors influence the manythousands of decisions made each day to buyor sell a currency? How do changes in supplyand demand conditions explain the path of anexchange rate over the course of a day, amonth, or a year?

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Term Paper Submitted

To..

MD.MOHIUDDIN

Course Lecturer

Course Title:

International Financial

Management

University of

Information

Technology & Science

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Term Paper Submitted

By..

Nafiz Imtiaz

ID: 10435246

Semester:3rd

Batch: 29th BBA

Holder.

RMBA.

Submis

sion


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In simple terms, it is the interaction ofsupply and demand factors for two

currencies in the market thatdetermines the rate at which theytrade. But what factors influence themany thousands of decisions madeeach day to buy or sell a currency?How do changes in supply anddemand conditions explain the path ofan exchange rate over the course of aday, a month, or a year?

This complex issue has beenextensively studied in economicliterature and widely

discussed among investors, officials,academicians, traders, and others.Still, there are no definitive answers.Views on exchange rate determinationdiffer and have changed over time. Nosingle approach provides asatisfactory explanation of exchangerate movements, particularly short-and medium-term movements, sincethe advent of

widespread floating in the early 1970s.

Three aspects of exchange ratedetermination are discussed below.First, there is a brief description ofsome of the broad approaches toexchange rate determination. Second,there are some comments on theproblems of exchange rateforecasting in practice. Third, centralbank intervention and its effects onexchange rates are discussed.

1. SOME APPROACHES TOEXCHANGE RATEDETERMINATION6

The Purchasing Power ParityApproach:

Purchasing Power Parity (PPP) theoryholds that in the long run, exchangerates will adjust to equalize therelative purchasing power of currencies. This concept follows fromthe law of one price, which holds thatin competitive markets, identicalgoods will sell for identical prices whenvalued in the same currency.

The law of one price relates to anindividual

product. A generalization of that law isthe absolute version of PPP, theproposition that

exchange rates will equate nationsoverall price

levels. More commonly used thanabsolute PPP

is the concept of relative PPP, whichfocuses on

changes in prices and exchange rates,rather

than on absolute price levels. RelativePPP holds

that there will be a change inexchange rates proportional to thechange in the ratio of the two nationsprice levels, assuming no changes instructural relationships. Thus, if theU.S. price


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level rose 10 percent and the Japanese price level rose 5 percent,the U.S. dollar would depreciate 5percent, offsetting the higher U.S.inflation and leaving the relativepurchasing power of the two

currencies unchanged.

PPP is based in part on someunrealistic assumptions: that goodsare identical; that all goods aretradable; that there are notransportation costs, information gaps,taxes,

tariffs, or restrictions of trade; and

implicitly and importantlythatexchange rates are influenced only byrelative inflation rates. But contrary tothe implicit PPP assumption, exchangerates also can change for reasons

other than differences in inflationrates. Real

exchange rates can and do changesignificantly

over time, because of such things as

major shifts in productivity growth,advances in technology, shifts infactor supplies, changes in marketstructure, commodity shocks,shortages, and booms.

In addition, the relative version of PPPsuffers from measurement problems:What is a good starting point, or baseperiod? Which is the appropriate price

index? How should we account for newproducts, or changes in tastes

and technology?

PPP is intuitively plausible and amatter of common sense, and itundoubtedly has some validitysignificantly different rates of inflation

should certainly affect exchange rates.PPP is useful in assessing long-termexchange rate trends and can providevaluable information about long-runequilibrium. But it has not met

with much success in predictingexchange rate movements over short-and medium-term horizons for widelytraded currencies. In the short term,PPP seems to apply best to situationswhere a country is experiencing veryhigh, or even hyperinflation, in whichlarge and

continuous price rises overwhelmother factors.

The Balance of Payments and theInternal-

External Balance Approach:

PPP concentrates on one part of thebalance of paymentstradable goodsand services and postulates thatexchange rate changes aredetermined by internationaldifferences in prices, or changes in

prices, of tradable items.

Other approaches have focused on thebalance

of payments on current account, or onthe balance of payments on currentaccount plus long-term capital, as aguide in the determination of theappropriate exchange rate. But intodays world, it is generally agreedthat it is essential to look at the entirebalance of paymentsboth currentand capital account

transactionsin assessing foreignexchange flows and their role in thedetermination of exchange rates.


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John Williamson and others havedeveloped

the concept of the fundamentalequilibrium

exchange rate, or FEER, envisaged asthe equilibrium exchange rate thatwould reconcile a nations internal andexternal balance. In that

system, each country would commititself to a

macroeconomic strategy designed tolead, in the medium term, to internalbalancedefined as unemploymentat the natural rate and minimalinflationand to external balancedefined as achieving the targetedcurrent account balance. Each countrywould be committed to holding itsexchange rate within a band or targetzone around the FEER, or the levelneeded to reconcile internal andexternal balance during theintervening adjustment period.

The concept of FEER, as an equilibrium

exchange rate to reconcile internaland external balance, is a useful one.But there are practical

problems in calculating FEERs. Thereis no unique answer to whatconstitutes the FEER; depending onthe particular assumptions, models,and econometric methods used,different analysts could come to quitedifferent results. The authorsrecognize this difficulty, and

acknowledge that some allowanceshould be made by way of a targetband around the FEER. Williamson hassuggested that FEER calculationscould not realistically justify exchangerate bands narrower than plus orminus 10 percent.

A METHODOLOGY FOR EXCHANGERATE ASSESSMENTS:

Oversight of members exchange ratepolicies is at the core of the IMFssurveillance mandate. The

methodology used for assessing theappropriateness of current accountpositions and exchange rates formajor industrial countries embodiesfour steps:

~ applying a trade-equation model tocalculate the underlying currentaccount positions that would emergeat prevailing market exchange rates if

all countries were producing at theirpotential output levels;

~using a separate model to estimate anormal or equilibrium level of thesaving-investment balance consistentwith medium-run fundamentals,including the assumption thatcountries were operating at potentialoutput;

~calculating the amount by which theexchange rate would have to change,other things being

equal, to equilibrate the underlyingcurrent account position with themedium-term saving

investment norm; and

~assessing whether the estimates ofexchange rates consistent withmedium-term

fundamentals suggest that anycurrencies are badly misaligned.


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The IMF, while generally agreeing thatit is not

possible to identify precise

equilibrium values for exchangerates and that point estimates ofnotional equilibrium rates shouldgenerally be avoided, does use amacroeconomic balance methodologyto underpin its internal IMF multilateralsurveillance. This methodology, whichis used for assessing the

appropriateness of current accountpositions and exchange rates formajor industrial countries.

The Monetary Approach:

The monetary approach to exchangerate determination is based on theproposition that exchange rates areestablished through the process ofbalancing the total supply of, and thetotal demand for, the national money

in each nation. The premise is that thesupply of money can be controlled bythe nations monetary

authorities, and that the demand formoney has a stable and predictablelinkage to a few key variables,including an inverse relationship to theinterest ratethat is, the higher theinterest rate, the smaller the demandfor money.

In its simplest form, the monetaryapproach

assumes that: prices and wages arecompletely

flexible in both the short and long run,so that PPP holds continuously, thatcapital is fully mobile across nationalborders, and that domestic andforeign assets are perfect substitutes.Starting from equilibrium in the money

and foreign exchange markets, if theU.S. money supply increased, say, 20percent, while the Japanese moneysupply remained stable, the U.S. pricelevel, in time, would rise 20 percentand the dollar would depreciate 20percent in terms of the yen. In thissimplified version, the monetaryapproach combines the PPP theorywith the quantity theory of moneyincreases or decreases in the moneysupply lead to proportionate increases

or decreases in the price level overtime, without any permanent

effects on output or interest rates.More

sophisticated versions relax some ofthe restrictive assumptionsforexample, price flexibility and PPP maybe assumed not to hold in the shortrunbut maintain the focus on therole of national monetary policies.

Empirical tests of the monetaryapproach simple or sophisticatedhave failed to provide an adequateexplanation of exchange ratemovements during the floating rateperiod. The approach offers only apartial view of the forces influencingexchange ratesit assumes away therole of nonmonetary assets such asbonds, and it takes no explicit accountof supply and demand conditions ingoods and services markets.

Despite its limitations, the monetaryapproach


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offers very useful insights. It highlightsthe importance of monetary policy ininfluencing exchange rates, andcorrectly warns that excessivemonetary expansion leads to currency

depreciation.

The monetary approach also providesa basis

for explaining exchange rateovershootinga

situation often observed in exchangemarkets in

which a policy move can lead to aninitial exchange rate move thatexceeds the eventual change impliedby the new long-term situation. In thecontext of monetary approach modelsthat incorporate short-term stickinessin prices,

exchange rate overshooting can occurbecause

prices of financial assetsinterest and

exchange ratesrespond more quicklyto policy moves than does the pricelevel of goods and services.

Thus, for example, a money supplyincrease (or decrease) in the UnitedStates can lead to a greater temporarydollar depreciation (appreciation) asdomestic interest rates decline (rise)temporarily before the adjustment ofthe price level to the new long-runequilibrium is completed and interestrates return to their original levels.

The Portfolio Balance Approach:

The portfolio balance approach takes ashorter-

term view of exchange rates andbroadens the

focus from the demand and supplyconditions for money to take accountof the demand and supply conditions

for other financial assets as well.Unlike the monetary approach, theportfolio balance approach assumesthat domestic and foreign bonds arenot perfect substitutes. According tothe portfolio balance theory in itssimplest form, firms and individualsbalance their portfolios amongdomestic money, domestic bonds, andforeign

currency bonds, and they modify their

portfolios as conditions change. It isthe process of equilibrating the totaldemand for, and supply of, financialassets in each country thatdetermines the exchange rate.

Each individual and firm chooses aportfolio to suit its needs, based on avariety of considerationsthe holderswealth and tastes, the level ofdomestic and foreign interest rates,expectations of future inflation,interest rates, and so on. Anysignificant change in the underlyingfactors will cause the holder to adjusthis portfolio and seek a newequilibrium.

These actions to balance portfolios willinfluence exchange rates.

Accordingly, a nation with a suddenincrease in

money supply would immediatelypurchase both domestic and foreignbonds, resulting in a decline in bothcountries interest rates, and, to theextent of the shift to foreign bonds, adepreciation in the nations home


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currency. Over time, the depreciationin the home currency would lead togrowth in the nations exports and adecline in its imports, and thus, to animproved trade balance and reversalof part of the original depreciation. As

yet, there is no unified theory ofexchange rate determination based onthe portfolio balance approach thathas proved reliable in forecasting. Infact, results of empirical tests of theportfolio balance approach do notcompare favorably with those fromsimpler models. These results reflectboth

conceptual problems and the lack ofadequate

data on the size and currencycomposition of

private sector portfolios.

3.MEASURING THE DOLLARSEQUILIBRIUM VALUE:

A Look at Some Alternatives:

As the discussion above indicates,there are various ways of estimatingthe dollars equilibrium value, andthey can yield a wide range of possibleresults. In its 1998 annual report, theBank for International Settlements(BIS) looks at three calculations of thedollars long-run equilibrium rate,which can be compared with thedollars market rates.

The three calculated rates consideredby the BIS are (1) Purchasing PowerParity (PPP), (2)

PPP adjusted for productivity, and (3)Fundamental Equilibrium ExchangeRates (FEER).8 As of mid-May 1998, on

the basis of a straight calculation ofPPP, the dollar appeared to beundervalued in the market (see tablebelow). On May 11, 1998 the dollarwas trading at 1.77 DEM and 132 yen.But to reach parity in PPP terms, the

dollar would have had to commandabout 15 percent more DEM and about30 percent more yen, using end-1996measures of PPP.

The calculations for PPP adjusted forproductivity show a different picture.Some analysts contend thatdifferences in productivity acrosscountries distort international

comparisons of broad consumptionbaskets used in PPP calculations. Theargument is made that countries suchas Japan with higher productivity inthe traded goods sector than in thenon-traded goods sector tend to havereal exchange rate appreciation, whichmakes their PPP appear to be higherthan it really is; and that there shouldbe an adjustment for this productivitybias. One such adjustment calculatedby Goldman Sachs suggests that the

dollar was not undervalued inadjusted-PPP

terms, but was overvalued by some 5-15 percent. The third approach hasbeen calculated by Swiss BankCorporation, using FEER, orfundamental equilibrium exchangerate concepts. This calculation alsosuggests that the dollar wasovervalued in the market in early 1998by as much as 20-30 percent against

the DEM and the yen.

As noted above, both PPP calculationsand FEER calculations can vary on thebasis of the assumptions, models, andtechniques used. In recent years, the


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United States has run substantialcurrent account deficitsa deficit of

more than $200 billion is expected in1998which might suggest anovervalued dollar. But the fact that

those current account deficits havebeen so easily financed by capitalinflows may

indicate that the dollar is stillconsidered a bargain at present levels.

Estimates of the U.S. DollarsPurchasing Power and FundamentalEquilibrium Value

Market Ratea

Against PPP Purchasing Power PPPAdjusted for Equilibrium

the Dollar Parity (PPP) ProductivityExchange Rate

OECDb Pennc Goldman Sachsd IIESBCd

Deutsche

mark 1.77 2.02 2.12 1.51 1.45-1.501.40

Japanese yen 132 169 188 124 100 95

On May 11, 1998.

1997 average.

1992.

Early 1998.

Nevertheless, the portfolio balanceapproach

offers a useful framework for studyingexchange rate determination. With itsfocus on a broad menu of assets, thisapproach provides richer insights thanthe monetary approach into the forcesinfluencing exchange rates. It also

enables foreign exchange rates to beseen like asset

prices in other markets, such as thestock market or bond market, whererates are influenced, not only bycurrent conditions, but to a greatextent by market expectations offuture events. As with other financialassets, exchange rates changecontinuously as the market receivesnew informationinformation about

current conditions and informationthat affects expectations of the future.

The random character of these assetprice movements does not rule outrational pricing. Indeed, it ispersuasively argued that this is theresult to be expected in a well-functioning financial market. But insuch an environment, exchange ratechanges can be large and very difficultto predict, as market participants tryto judge the expected real rates of

return on their domestic assets incomparison with alternatives in othercurrencies.

How Good Are the VariousApproaches?:

The approaches noted above are someof the most general and most familiarones, but there are many others,focusing on differentials in realinterest rates, on fiscal policies, andon other elements. The research onthis topic has been of great value inenhancing our understanding of long-run exchange rate trends and theissues involved in estimatingequilibrium rates. It has helped usunderstand various aspects of


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exchange rate behavior and particularexchange rate episodes.

Yet none of the available empirical

models has

proved adequate for making reliablepredictions of the course of exchangerates over a period of time. Researchthus far has not been able to findstable and significant relationshipsbetween exchange rates and anyeconomic fundamentals capable ofconsistently predicting or explainingshort-term rate movements.

2. FOREIGN EXCHANGEFORECASTING IN PRACTICE

Most of the approaches to exchangerate determination tell only part of thestorylike

the several blindfolded men touchingdifferent

parts of the elephants bodyandother, more

comprehensive explanations cannot,in practice, be used for preciseforecasting. We do not yet have a wayof bringing together all of the factorsthat help determine the exchange ratein a single comprehensive approachthat will provide reliable short- tomedium-term predictions.

The exchange rate is a pervasive andcomplex

mechanism, influencing and being

influenced by

many different forces, with the effectsand the

relative importance of the differentinfluences

continuously changing as conditionschange. To

the extent that trade flows are a forcein the market, competitiveness is

obviously important to the exchangerate, and the many factors affectingcompetitiveness must be considered.

To the extent that the money marketis a factor, the focus should be onshort-term interest rates, and onmonetary policy and other factorsinfluencing those short-term interestrates. To the extent that portfoliocapital flows matter, the focus shouldbe broadened to include bond marketconditions and long-term interest

rates. Particularly at times of greatinternational tension, all other factorsaffecting the dollar exchange rate maybe overwhelmed by considerations ofsafe haven.

Indeed, countless forces influence theexchange

rate, and they are subject tocontinuous and

unpredictable changes over time, by amarket that is broad andheterogeneous in terms of the

participants, their interests, and theirtime frames.


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With conditions always changing, theimpact

of particular events and the responseto particular policy actions can varygreatly with

the circumstances at the time. Higherinterest

rates might strengthen a currency orweaken it,

by a small amount or by a lotmuchdepends

on why the interest rates went up,

whether a move was anticipated, whatsubsequent moves are expected, andthe implications for other financialmarkets, decisions, or governmentpolicy moves. Similarly, the results ofexchange rate changes are not alwayspredictable: Importers might expect topay more if their domestic currencydepreciates, but not if foreignproducers are pricing to market inorder to establish a beachhead ormaintain a market share, or if the

importers or exporters had anticipatedthe rate move and had acted inadvance to protect themselves from it.

Nonetheless, those participating in themarket must make their forecasts,implicitly and explicitly, day after day,all of the time. Every piece ofinformation that becomes availablecan be the basis for an adjustment of

each participants viewpoint, orexpectationsin other words, aforecast, informal or otherwise. Whenthe screen flashes with an unexpectedannouncement that, say, Germany hasreduced interest rates by a quarter ofone percent, that is not just news, it isthe basis for countless assessments ofthe significance of that event, and

countless forecasts of its impact innumber of basis points.

Those who forecast foreign exchange

rates often are divided into those whouse technical analysis, and thosewho rely on analysis of fundamentals, such as GDP,investment, saving, productivity,inflation, balance of paymentsposition, and the like. Technicalanalysis assumes certain short-termand longer-term patterns in exchangerate movements. It differs from therandom walk philosophythe beliefthat all presently available information

has been absorbed into the presentexchange rate, and that the next

ASSESSING FACTORS THAT MAYINFLUENCE EXCHANGE RATES

In the end, it is up to each marketparticipant to decide, in eachparticular situation, which factors arelikely or not likely to move anexchange rate, and what the impacton market expectations will be. It is amatter of judgment; marketparticipants must read the market,decide which data are important, howmuch weight to give them, andwhether and in what way to reactand often these assessments must bemade very quickly. Among theconsiderations to keep in mind inassessing a new piece of information:

1. The Institutional Setting


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* Does the currency float, or is itmanagedand if so, is it pegged toanother currency,

basket, or other standard?

* What are its intervention practices?Are they credible, sustainable?

2. Fundamental Analysis

* Does the currency appearovervalued or undervalued in terms ofPPP, balance of

payments, FEER?

* What is the cyclical situation, interms of employment, growth,

savings, investment, and inflation?

* What are the prospects forgovernment monetary, fiscal, and debtpolicy?

3. Confidence Factors

* What are market views andexpectations with respect to thepolitical environment, and the

credibility of the government and

central bank?

4. Events

* Are there national or internationalincidents in the news; possibility ofcrises or

emergencies; governmental or otherimportant meetings coming up?

5. Technical Analysis

* What trends do the charts show? Arethere signs of trend reversals?

* At what rates do there appear to beimportant buy and sell orders? Arethey balanced? Is the market over-bought, over-sold?

* What are the thinking andexpectations of other market playersand analysts?

piece of information as well as thedirection of Nearly all tradersacknowledge their use

the next rate move is random, with a50 percent of technical analysis andcharts. According chance the rate willrise, and 50 percent chance tosurveys, a majority say they employtechnical it will decline. analysis to agreater extent than fundamentalanalysis, and that they regard it as

more useful than fundamental analysisa contrast to twenty years ago whenmost said they relied many moreheavily on fundamental analysis.Perhaps traders use technical analysisin part because, at least superficially,it seems simpler, or because the dataare more current and timely. Perhapsthey use it because traders often havea very short-term time frame and areinterested in very short-term moves.

They might agree that fundamentals

determine the course of prices in thelong run, but they may not regard thatas relevant to their immediate task,particularly since many fundamentaldata become available only with longlags and are often subject to majorrevisions. Perhaps traders thinktechnical analysis will be effective inpart because they know many othermarket participants are relying on it.

Still, spotting trends is of realimportance to tradersa trend is afriend is a comment

often heardand technical analysiscan add


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some discipline and sophistication tothe process of discovering andfollowing a trend. Technical analysismay add more objectivity to makingthe difficult decision on when to giveup on a positionenabling one to see

that a trend has changed or run itscourse, and it is now time forreconsideration.

Most market participants probably usea combination of both fundamentaland technical analysis, with theemphasis on each shifting asconditions changethat is, they forma general view about whether a

particular currency is overvalued orundervalued in a structural or longer-term sense, and within that longer-term framework, assess the order flowand all current economic forecasts,news events, political developments,statistical releases, rumors, andchanges in sentiment, while alsocarefully studying the charts andtechnical analysis.

3. OFFICIAL ACTIONS TOINFLUENCE EXCHANGE RATES

As in some other major industrialnations with

floating exchange rate regimes, in theUnited States there is considerablescope for the play of market forces indetermining the dollar exchange rate.But also, as in other countries, U.S.authorities do take steps at times to

influence the exchange rate, via policymeasures and direct intervention inthe foreign exchange market to buy orsell foreign currencies. As notedabove, in practice, all foreignexchange market intervention of theU.S. authorities is routinely sterilizedthat is, the initial effect on U.S. bank

reserves is offset by monetary policyaction.

No one questions that monetary policymeasures can influence the exchangerate by

affecting the relative attractiveness ofa currency and expectations of itsprospects, although it is difficult tofind a stable and significantrelationship that would yield apredictable, precise response. But thequestion of the effectiveness ofsterilized intervention, which has beenextensively studied and debated, ismuch more controversial. Someeconomists contend that sterilized

intervention can have, at best, amodest and temporary effect. Otherssay it can have a more significanteffect by changing expectations aboutpolicy and helping to guide themarket. Still others believe that theeffect depends on the particularmarket conditions and the interventionstrategy of each situation. Given thepresent size of U.S. monetaryaggregates, balance of paymentsflows, and the levels of activity in the

foreign exchange market and otherfinancial markets, it is widelyaccepted that any effects of sterilizedintervention are likely to be throughindirect channels rather than throughdirect impact on these largeaggregates. Empirical tests ofsterilized intervention have focused ontwo main channels through which suchintervention

might indirectly influence the

exchange rate:

the portfolio balance channel and theexpectations, or signaling, channel.

The portfolio balance channelpostulates that the exchange rate isdetermined by the balance of supply


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and demand for available stocks offinancial assets held by the privatesector. It holds that sterilizedintervention will alter the currencycomposition of assets available to theglobal private sector, and that if dollar

and foreign currency-denominatedassets are viewed by investors asimperfect substitutes, sterilizedintervention will cause movements inthe exchange rate to re-equilibratesupply and demand for dollar assets.

The size of this portfolio balance effectwould depend on the degree ofsubstitutability between assetsdenominated in different currenciesand on the size of the interventionoperation.

The expectations, or signaling,channel holds that sterilizedintervention may cause private agentsto change their expectations of thefuture path of the exchange rate.

Thus, intervention could signalinformation about the future course ofmonetary or other economic policies,signal information about, or analysis

of, economic fundamentals or markettrends, or influence expectations byaffecting technical conditions such asbubbles and bandwagons.

A considerable number of studies havefound

no quantitatively important effects ofsterilized

intervention through the portfoliobalance

channel. Some studies have foundexpectations

or signaling effects of varying degreesof

significance. Others conclude that theeffectiveness

depends very much on marketconditions and

intervention strategy.

There are serious data andeconometric problems in studying thisquestion. To assess success, theresearcher needs to know theobjective of the intervention and otherspecific detailswas the aim toameliorate a trend, stop a trend,

reverse a trend, show a presence,calm a market, discouragespeculation, or buy a little time?

The researcher also needs to know the

counterfactualwhat would havehappened if the

intervention had not taken place.

Also, research on this issue must beplaced in the broader context ofresearch on exchange ratedetermination, which, as noted above,indicates that it has not been possibleto find stable and significantrelationships between exchange ratesand any economic fundamentals.

As a practical matter, it is difficult tomake sweeping assessments aboutthe success or failure of official

intervention operations. Someintervention operations have provenresoundingly successful, while othershave been dismal failures. Thesuccess or failure of intervention is notso much a matter of statisticalprobability as it is a matter of how it isused and whether conditions are


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appropriate. Is the objectivereasonable? Does

the market look technicallyresponsive? Is interventionanticipated? Will an operation look

credible? What is the likely effect onexpectations?

In 1983, the Working Group on ForeignExchange Market Interventionestablished at the Versailles summit ofthe Group of Seven warned againstexpecting too much from officialintervention, but concluded that suchintervention can be a useful andeffective tool in influencing exchangerates in the short run, especially whensuch operations are consistent withfundamental economic policies.Unquestionably, interventionoperations are

more likely to succeed when there is aconsistency with fundamentaleconomic policies, but it may notalways be possible to

know whether that consistency exists.Although attitudes differ, monetaryauthorities in all of the major countriesintervene in the foreign exchangemarkets at times when they considerit useful or appropriate, and they arelikely to continue to do so. The currentattitude toward foreign exchangemarket intervention is summarized inthe following excerpt from the

June 1996 report of the finance

ministers of the Group of Sevennations:

CONTINUING CLOSE G7COOPERATION IN EXCHANGEMARKETS

Exchange rate misalignments canheighten uncertainty in the globaleconomy and can be

detrimental to growth and trade.When exchange rates appear to moveout of line with underlyingfundamentals, close monitoring isnecessary and coordinated responsesmay be required.

We should continue our closecooperation in exchange markets inthis foundation, taking into

account the fact that:

--A clear and consistent articulation ofa common G7 view can have astabilizing influence and help reinforcethe credibility of our commitment tocooperate in the exchange marketwhen circumstances warrant;

--interventions can be effective in

certain circumstances, especiallywhen they reinforce changes inpolicies and/or underlyingfundamentals that lead to changes inmarket expectations about futureexchange rates;

--the instrument of intervention mustbe used judiciously, given itsimplications for monetary policy andthe amount that the authorities can

mobilize relative to the size ofinternational capital markets.Nevertheless, these factors do notimpede our joint ability to send a clearmessage to the markets, if and whenappropriate;


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-- interventions are more likely to beeffective when they are concerted andreflect a common assessment.

the ditermination of exchange rate (assignment)

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