Monday, May 7, 2012

Government intervention in exchange rate

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Since 18, Australia has had a floating exchange rate. Under this system, exchange rates are determined by the free market forces of supply and demand.The Reserve Bank of Australia (RBA) may undertake foreign exchange market operations when the market threatens to become excessively volatile or when the exchange rate is clearly inconsistent with underlying economic fundamentals. Initially, the Reserve Bank of Australia was not intended to intervene in the market however since then it has been deemed necessary for intervention to take place, usually to prop up the price. These operations are invariably aimed at stabilising market conditions rather than meeting exchange rate targets.

there are a number of reasons why central banks choose to intervene in foreign exchange markets to affect the equilibrium value of their domestic currency.

First, it is to reduce unnecessary volatility in the exchange rate in order that the currency depreciation will fuel domestic inflation. Second, RBA increases the prices of imported goods. Third, the RBA intervenes regularly in foreign markets in australia for testing and smoothing purpose. that is, it enters the foreign market from time to time to test the market trends and to smooth out large transactions, eliminating unnecessary fluctuations in the foreign exchange value of the australian dollar.

in contrast, there are two primary arguements against the RBA intervening in the foreign exchange market. the first is the thenical issue of at what level to fix the value of the domestic currency. if the RBA attempts to fix the exchange rate at a level that is fundamentally different from the equilibrilum value that would arise in a flexible regime, then the RBA will either be running down its stock of foreign reserves- in the case where it has overvalued the domestic currency - or it will be continually building up its stock of foreign reserves - in the case where it has undervalue the domestic currency.

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the second, more important, arguement against fixing exchange rate is that fixed exchange rate remove the ability of RBA to operate independent domestic monetary policies.

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