Term Paper on "Exchange Rates and Inflation Can Manipulating Currency"

Term Paper 20 pages (5277 words) Sources: 1+

[EXCERPT] . . . .

exchange rates and Inflation

Can manipulating Currency Rates effectively reduce inflation?

Recent trend have shown that developing countries have been prone to higher inflation than industrialized countries. This trend has formed the basis of monetary policy in these countries since the early 1980s (Bleaney and Fielding, 2005). Bleaney and Fielding surmised that inflation could be controlled in these countries by adjusting currency exchange rates. Bleaney and Fielding suggest that the method of pegging the developing nation's currency exchange rate to the currency of a more advanced nation, or perhaps a basket of such currencies was the most effective means to control inflation.

This was the method that dominated the monetary policy of developing nations before the 1980s. However, in the mid 1980s things began to change as developing nations began to move towards capital market systems and enter into the global marketplace. Advances in communications and technology made it possible for developing nations to compete on a global basis and they began to adjust their monetary policy to resemble more closely those of industrialized nations.

We have seen this in Asia and South America in recent years. When developing nations changed monetary policy, they soon found that there was a right way and a wrong way to do this. Countries such as Brazil and Mexico experienced dramatic rises in inflation as a result. They had to adopt drastic policies to control runaway inflation and regain some order in their economy. Other countries, such as Morocco, took these lessons to heart and adopted floating exchange rates at a much slower pace. This helped to ease the transition.

This research user regression analysis to support the hypothesis that inflation rates will be directly related to changes in its currency exchange rate among developing nations. In order to accomplish this task the study will examine data from developing nations and industrialized nations using a regression analysis to determine if any correlation exists.

Theoretical Basis of Analysis

Governments have several mechanisms available to them to assist in the regulation of their fiscal health. Manipulating the exchange rate and the adoption of various monetary policies are only two of the solutions available to manage the economy. These are the two most commonly used mechanisms to assure that their currency retains value and that they do not experience run away inflation and all of the ills that come with it.

The goal of every government is stability in the economy. They seek to avoid scenarios such as high inflation, currency devaluation and other situations that would harm their ability to maintain peace within their boundaries. Low inflation and the ability to maintain their competitive position on the global marketplace have become major goals of policy makers around the globe. One of the key characteristics of an industrialized nation is fiscal and political stability. Developing nations are associated with monetary volatility and political upheaval. In order to ease pressures, many developing nations have decided to adopt policies similar to those used by industrialized nations in hopes of achieving similar stability and peace. Let us examine how monetary policy is used to achieve this goal.

Monetary Policy and Exchange Rate

The real exchange rate is used as a measure to assess the countries competitiveness as compared to other countries around the globe. Inflation tells us less about the fiscal health of the country than real exchange rate. Inflation is derived from monetary expansion, the devaluation of currency and other factors. One of the key difficulties is that different measures are used to report these indices. When one wishes to compare inflationary indices of different countries, one has to be certain that they are comparing like factors. This is one the difficulties in using a regression analysis to assess the relationship between two factors. Differences in the way inflationary indices are reported may affect the ability to draw conclusions about the relationship between exchange rate and inflation in developing countries.

Countries can choose several different structures for their exchange rate policy. They can use a fixed rate policy where their exchange rate is directly tied to that of another country, such as the United States or France. They can also choose a variable rate that that allows them much more flexibility to respond to shocks within their economy. This type of exchange rate is referred to as a floating exchange rate. A fixed rate policy ensures more stability but does not allow them to respond to situations as they arise.

The type of policy chosen depends on the specific needs of a particular country. The type of exchange rate policy directly affects the ability to draw a correlation between exchange rates and inflation. Countries that use a floating exchange rate would be more responsive to monetary shocks, such as rising interest rates or changes in GDP. Many developing nations use a fixed exchange rate. However, as they evolve toward becoming an industrialized nation, they will often adjust their exchange rate so that it is more responsive to the market.

In several cases, during the time period examined by this study, countries changed their fiscal policies. These examples are the most interesting as far as examining the correlation between exchange rates and inflation are concerned. These countries provide an example where one can examine the independent variable (inflation) before and after the adoption of new monetary policies involving exchange rates.

A prime example of a country that changed its exchange rate policy from a fixed rate to a floating rate is Kenya. Until 1974 Kenya's exchange rate was pegged to the U.S. dollar. However, after several devaluations they dropped the peg and decided to tie the currency directly to the markets. Kenya now has a floating exchange rate (Calvo and Reinhart, 2001). Many countries that were previously tied to the U.S. dollar have chosen to peg to a basket of currencies as a result of devaluation of the Dollar (Calvo and Reinhart, 2001). All of these changes have an effect on the analysis of exchange rate and inflation.

An understanding of the different types of exchange rate policies and how their effects on volatility are imperative in the development of a model for the conduct of this study. Fixed exchange rates are not reflective of the actions and reactions that are taking place within the country itself, but rather reflect the movements of the country to which the exchange rate is pegged. Fixed exchange rates are not as reactionary to changes within the country as floating exchange rates. Therefore only countries that use floating exchange rates will be examined.

International trade has caused many formerly third world countries to adopt an exchange that more closely follows the markets. Many are choosing a floating exchange rate rather than a pegged one. Morocco and Tunisia recently made this move. Until 1984 their markets were pegged to the French Franc, but in 1984 they decided to peg their exchange rates to the international markets (Grand and Dropsy, 2004). This has the effect of making their country more attractive to investors because there is a considerable chance for growth. However, when Latin countries made this move it led to currency overvaluation. To avoid this same situation Morocco and Tunisia developed a plan to manage the currency rate while the markets were being developed. The than from a pegged currency to a floating one requires carefully planning and is usually accomplished in stages.

There is another type of exchange rate that may affect this analysis. As countries are making the transition from a fixed exchange rate to a floating one, they may decide to use what is called a managed floating exchange rate. The terms of managed exchange rates differ from country to country. Managed exchanged rates allow the exchange rate to float with the market, but have mechanisms in place to prevent unwanted effects such as runaway inflation and a drop in the GDP.

The purpose of this research is to measure interaction between exchange rates and inflation, in order to effectively accomplish this task necessitates the most highly reactionary variable possible. Using countries that have a fixed or managed floating exchange rate do not offer a true measure of market reaction,. Therefore only countries that use a floating exchange rate will be used for this regression analysis. Special cases such as countries that changed their exchange rate policy will be examined both before and after the monetary policy change to examine the effects of the policy more closely.

There are many factors that cannot be controlled for in the course of this research, such as the methods used to measure inflation, GDP, and other market indices. These factors may affect the outcome of the results of this research. However, at the current time there is no standard method for reporting these factors. However, many of the countries conform to the standards set by industrialized nations and it can be assumed that the information is accurate. Data will be obtained from credible sources such as the OECD, WMF, and the U.S. Bureau… READ MORE

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