[Dec 2007, Volume 4 Quarterly Issue] Pdf File size - The IIPM Think ...

MORE MARKETS, LESS GOVERNMENT
Figure 2: Pre- reform Exchange Rate Variability
government running a very high deficit
will be reluctant to adopt an expansionary
monetary policy because of its ineffectiveness
in a fixed rate regime.
Macroeconomic stability is a priority
for any economy and all governments
(irrespective of exchange rate regime)
tend to intervene in the forex markets
in order to influence the exchange rate.
The government can take direct or indirect
measures to counter exchange
rate movements. Direct measures involve
trading in the forex market. The
government uses its foreign exchange
reserves to affect demand and supply in
the forex market. For example, if domestic
currency is depreciating the government
will buy excess money supply
by selling forex reserves to stabilize
supply demand imbalances. The government
can further offset this contractionary
effect in domestic money supply
by a simultaneous and equal purchase
of domestic currency bonds. Such intervention
is called “sterilized intervention”
and is preferred by most governments.
Such direct measures of
intervention are complemented by some
indirect measures like trade and interest
rate restrictions to affect the demand
and supply of foreign currency.
For example, variable interest rates will
affect the capacity of importers. One
example is an interest rate surcharge on
import finance: In order to curb imports
and retain forex reserves, the RBI
increased the interest rate surcharge on
import finance from 15 percent to 25
percent in January 1996.
THE INDIA ECONOMY REVIEW
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