Exchange Rate Policy In Bangladesh: A Review Of Key Concepts And Issues

Exchange Rate Policy in Bangladesh: A Review of Key Concepts and Issues

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In an open and deregulated economic environment, exchange rates can play an important role in macroeconomic management for stability and growth. The increasing role of exchange rates since the early 1970s has indeed been a break from the Bretton Woods tradition of the 1950s and 1960s that assigned a limited role for exchange rates in economic affairs. However, the banking and currency crises of the 1990s that afflicted many developing countries in different regions have provided a somber lesson that in a global economic setting, exchange rate policy, and monetary and financial policy more broadly, cannot be treated in a business as usual fashion. This is more so for countries, which have underdeveloped financial systems, poor governance but open capital accounts. The stake is indeed high because the way an emerging market economy conducts its exchange rate policy does have a profound impact on its current and future macroeconomic performance. As the experiences of various countries in Asia, Africa and Latin America suggest, economic, social and political costs of mis-aligned real exchange rates, policy-induced or structural, could be formidable (Edwards, 1989; Ghosh, Lane, Schulze-Ghattas, Bulir, Hamann and Mourmouras, 2002). Therefore, it becomes a vital policy issue to choose an exchange rate system that is compatible with a developing economy's characteristics and needs.

I. Exchange Rate Policy and Exchange Rate Management

In the simplest sense, exchange rate policy addresses the management of rates at which the domestic currency is converted to another currency(ies) by a public agency such as a central bank. These rates can be converted at a fixed rate or a floating(changing) rate. Exchange rate policy is managed in one of two ways: through

a fixed rate or through

a floating rate.

Management, under a floating exchange rate system, can be defined in a broad sense to include both direct intervention by the public agency in foreign exchange markets and changes in interest rates (monetary policy instrument). Thus, exchange rate policy remains closely related to monetary policy and could be synonymous with it depending on the country's exchange rate arrangements. For example, when the authorities of a country adopt a fixed or pegged exchange rate system, they lose control over monetary policy, provided that there is perfect capital mobility. In practical sense, this means that the domestic currency interest rate (id) equals the foreign currency interest rate (if) plus any country risk premium (r ) on holding domestic currency assets. This relationship follows the uncovered interest rate parity condition: id = if + r + d , where d is expected rate of depreciation of the domestic currency.1 Under a fixed exchange rate system that is credible, d is zero and, if there is no country risk premium, id equals if . It is only when the exchange rate floats independently, the central bank gains control over monetary policy, in the sense that it can set the domestic currency interest rate irrespective of the foreign currency interest rate. However, the above formula (the uncovered interest rate parity condition) suggests that, at equilibrium, the domestic currency interest rate would deviate from the foreign currency interest rate to the extent measured by r + d , where d can be approximated by the inflation differential between the home and foreign countries. Therefore, given foreign inflation and domestic risk premium, the concept of independent monetary policy, meaning the ability to set the domestic interest or inflation rate, makes sense when the exchange rate is floating.

By definition, under a fixed or pegged exchange rate system, the nominal exchange rate remains fixed. However, one measure of the real exchange rate (defined below) would show that the real exchange rate can change under this system when there is an inflation differential between the home and foreign countries. Exchange rate management, under a fixed or pegged exchange rate system, then means an adjustment of value of the nominal exchange rate in such a way that would keep the actual real exchange rate close to the long-run equilibrium real exchange rate. The long-run equilibrium exchange rate, in turn, could be defined as a value of the real exchange rate that is simultaneously consistent with internal and external balance of the economy (Edwards, 1989).2

Thus the rationale behind changing the nominal exchange rate under a fixed or pegged exchange rate system is easy to follow provided that the set rate is found to be far away from the optimal or equilibrium rate. However, why does the central bank need to manage exchange rates which are determined by market forces in case of independent floating? This remains a contentious issue. Essentially, the central bank is believed to determine the appropriate level (or path) of the nominal exchange rate and then intervene in foreign exchange markets to bring the actual exchange rate close to the appropriate level. In practical sense, the appropriate level of the exchange rate may represent the rate which, when translated into a real exchange rate, is consistent with the long-run equilibrium real exchange rate. Many economists of neoclassical persuasion believe that the market determined exchange rates broadly represent the long-run equilibrium exchange rates and there is no need for managing exchange rates or intervention in foreign exchange markets. Moreover, according to them, as exchange rates are essentially prices (not contracts) and provide information on conditions in assets markets, any management of the exchange rates may lead to resource misallocation and loss of economic efficiency. There are, however, counter arguments that condone intervention in foreign exchange markets. The logic behind such intervention is that market determined exchange rates do not necessarily represent optimal or equilibrium exchange rates. First, producers of the exchange rates in foreign exchange markets could be motivated differently from those who consume them in both the goods and assets markets. Second, due to stickiness of goods' prices, any movements of the nominal exchange rates lead to movements of the real exchange rates from their equilibrium levels. Third, policies and markets are not perfect, so market determined outcomes might not be optimal.

II. The Real Exchange Rate: Meaning, Measurement and Importance

It is the real, not necessarily the nominal exchange rate that matters for trade flows. However, while the nominal exchange rate is "visible", the real exchange