Question

You have been assigned the role to Advise the FEDERAL RESERVE on how to BEST manage the Exchange Rate.

Write a detailed note explaining to the Governor what tools are available and what would be your strategy in defending the currency against speculative market forces?

Answer : Defending the exchange rate of a currency is a complex business ……

Answer 1

Ans: Defending Exchange rate is a complex business , as exchange rate is affected by many factors like : Inflation, Balance of payment, Country's growth rate, Federal reserve rate along with bank rate decided by federal reserve.

It can be well manage by doing some changes in the economy. In this particulat situation federal reserve need to change its reserve requirement for banks functions in that country. As reserve rate decreases banks tends to supply more money in to the market. this is how exchange rate of currencies affected.

By increasing reserve rate, banks donot allow currencies supply in to the market. and Dollar become more stable with respect to other currencies.

Major tools here are as follows:

Inflation rate.

Banks rate, interest rate.

Hedging with money markets

Hedging with forward and options instruments.

Currency speculation is when investors buy bulk amount of share and hope the share price it will be high in future and resulting profit for them. this create high demand of share in the market and raise the exchange rate. so in order to defend this situation federal reserve need to raise interest rate for non negligible period to control speculation.

You have to hold more foreign reserve to tackle currency speculation in the market.