Foreign exchange markets, intervention and exchange rate regimes

Abstract

While macroeconomic fundamentals determine the exchange rate at long horizons, there are substantial and persistent deviations from these fundamentals. The market micro structure within which they operate, macroeconomic fundamentals, and policies all affect foreign exchange (FX) markets. The paper describes the institutional features of these markets, with special emphasis on the process of liberalization and deepening in Indian FX markets, in the context of global integration. Since the mechanics of FX trading affect exchange rates, they have implications for the appropriate exchange rate regime. First, bounds on the volatility of the exchange rate can lower noise trading in FX markets, decrease variance, improve fundamentals and give more monetary policy autonomy. Second, the speculative demand curve is well behaved under strategic interaction between deferentially informed speculators and the Central Bank (CB) when there is greater uncertainty about fundamentals as in emerging markets. So a diffuse target and strategic revelation of selected information can be expected to be effective. Analysis of Indian experience confirms these research results. CB actions, including intervention and signaling, have major effects.