Authorities might be able to produce a more approp...
For a variety of reasons the exchange rate produced by the market may be the wrong rate compared to underlying economic fundamentals.The market may use the wrong model; it may have the wrong perception about the future, and will have difficulty in interpreting the implications of news relevant to the exchange rate.However, the fact that the market may produce the wrong rate does not necessarily justify intervention by the authorities.It is necessary to demonstrate that the authorities can choose a more appropriate rate.
There exists a case for intervention if the news or information available to the market is efficiently used but the news itself is either inadequate, for example, increasing risk, or misleading and the authorities are in possession of superior relevant information.Intervention in such circumstances can prove both stabilizing and profitable.However, it could be argued that a superior policy is for the authorities to abstain from intervention and release the relevant information to the market.Nevertheless, there may be circumstances under which such an information release is not considered desirable and even if the authorities were to release the relevant information, there is no guarantee that the market would believe them.
Connected with the above argument is a far more convincing reason for the authorities to intervene.While it may be the case that they do not know any more than the market regarding what is the correct rate, they should know better and sooner what they themselves are about to do.Since the exchange rate is an asset price it incorporates expectations concerning its future price appropriately discounted into the current price so that usually ex ante speculative profits cannot be made.For example, if the money supply is expected to increase at a given date in the future, this implies a depreciation of the exchange rate; if the exchange rate did not depreciate until the expected increase in the money supply took place this would imply a large discrete depreciation of the exchange rate at that time.However, since the depreciation was expected such a discrete jump would imply a missed abnormal ex ante profit opportunity.Since the foreign exchange market is efficient the expectation of a depreciation leads to a smaller discrete depreciation of the current rate, with a gradual depreciation thereafter until the actual increase in the money supply takes place.In this way all anticipated disturbances are fully discounted and therefore unusual ex ante profit opportunities eliminated.
The point is that the authorities should be more capable than the market in predicting the future course of their policies, and this is of relevance to the correct exchange rate.Given this, intervention in the foreign exchange market may be interpreted by the market as a commitment by the authorities to adopt a given course of action; if this is the case, economic agents may more readily lend their support to the new policy helping to make it more effective than would otherwise be the case.Thus, there exists a case for official intervention on the grounds that the authorities have a better knowledge of their future policy intentions than private market participants.Official intervention in the future exchange market may literally “buy credibility” convincing economic agents that the authorities intend to fulfill their stated domestic policy targets by committing the assets of the Central Bank in support of its declared future policy.A key postulate of the rational expectations literature is that the authorities will only be able to achieve their short-run inflation objectives painlessly if economic agents are convinced that the authorities intend to carry out their stated objectives.The opportunity to purchase some credibility by intervening in the foreign exchange market could prove to be a useful policy tool.
To illustrate the above point, consider the case where there is news of an increase in the rate of growth of the money supply; this may be viewed as affecting speculators’ expectations in at least three possible ways: it may be seen as only a transitory development of a counter-cyclical nature that will subsequently be reversed; or, it may be seen as a once-and-for-all change in the money stock that will not be reversed but which will not affect the underlying rate of growth of the money stock; or, alternatively, it may be seen as heralding a more permanent increase in the rate of growth of the money stock.Each of these alternatives has different implications concerning the required depreciation of the currency; the greater the actual growth the greater the required depreciation.There is no prior reason to believe that the market, in the short run at least, will know what the required depreciation is; the authorities, however, should know and could indicate their feeling regarding the appropriate rate via an intervention policy.