Foreign Currency & The Economy
Author: Ashish Ghangrekar
This paper attempts to discuss about the relation between Foreign Currency & the Economy. The paper develops the correlation between foreign currency & the economy. It further goes on to discuss the various parameters that affect this correlation. Finally, a few hypotheses drawn from the discussion are presented at the end of the paper.
Foreign Exchange & foreign currency is the elastic link between various independent political states. The Central Bank of a country frames the monetary policy to maintain a desirable Foreign exchange rate & regulate the flow of foreign currency in an economy.
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FDI is a strategic inflow of foreign currency on which returns have to be paid to the investor in the form of dividends or interests. Such an investment can be withdrawn by the foreign investor in case of any instability or any unfavorable conditions created in the economy. This would result in the devaluation of the domestic currency as in the case of the Asian crisis of 1997 which is discussed later. Thus foreign currency in terms of FDI or in the form of a financial aid can increase the dependence of an economy over bigger capitalist nations. This will give rise to economic dominance by the bigger nation & hence build a case for imperialism. For example, many of the African country have been crippled by providing them an aid & increasing the political hold in those countries. On the other hand, the foreign currency inflow arising due to trade gives an economic drive to the economy. It is an indicator of the production might like in case of China or presence of a strong services capability like in case of India.
So what is the sound practice for an Economy to emerge as a global potent force? Historically the current superpower economies of the US or Japan have developed a stronger backbone by setting up sound domestic financial institutions in the first half of the 20th century. They followed Monetary Mercantilism by adopting policies such as maintaining low interest rates, floating exchange rates & generating trade surplus by keeping its currency undervalued. Another observation is that, there have always been prior political reforms in a country before any form of economic reforms. For example after opening its economy in 1991, India has implemented sound policies to give its economy a boost & has emerged as a global hub for IT exports & other outsourcing jobs. Since its independence in 1947 till the 1991 liberalization , India had to undergo a political upheaval under a socialist framework which gave way to economic reforms.
Let us now look at some key areas that cause the dynamics between the foreign currency & an economy.
Free / Floating Exchange Rate Regimes:
The Central Bank varies the interest rates based on the inflation target it needs to maintain in the country. In such cases, any increase in the interest rate will increase the demand for the domestic currency & hence increasing the exchange rate. It is exactly the opposite in the case of cutting interest rates. Such a regime is called as the Floating Exchange rate regime which is purely controlled by the Market forces. The central bank can intervene from time to time to adjust the policy / interest rate to meet its prime objectives. This is known as ‘Managed Float’ & arises in the accumulation or selling of foreign reserves.
However in the case of closed economies, the currency is pegged or the exchange rate is fixed. The central bank cannot vary the interest rates to control inflation. The price levels in the economy can be controlled only by curbing the Government...