Predictability of Foreign Exchange Rates

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are the various implications of the change in predictability of exchange rates on the domestic and international markets?

 What can be done to stabilize exchange rate and thus, make them more predictable?

An evaluation of the predictability quotient of the exchange rates before and after the collapse of the fixed rate regime will highlight the flaws existent in the Bretton Woods system and also show whether the new system of flexible exchange rate has been successful in reforming those flaws. Through a comparative analysis of predictability of exchange rates in these two periods of time, it can be examined whether the adoption of free and floating exchange rate and the abolition of pegged exchange rates was justified or not. The study of the variations in the US currency, relative to the currencies of other nations can be used as a specific example to support the theoretical views and inferences on the change in predictability of exchange rates. Identifying the various causes of the rise or fall in exchange predictability in recent times will stress the importance of stable exchange rates, focusing on its different implications on trade and stability of the economy. Finally, having identified all the problems associated with the developments in exchange rate predictability since the breakdown of the Bretton Woods System in 1973 to current times will help us arrive at effective solutions to these problems.

II. Literature Review:

Exchange Rates and their Importance:

“The Exchange Rate is the price of one currency in terms of another”. (Krueger, 1983, p.62) It is a measure of how much of one currency has to be exchanged for one unit of another currency. For example, if the current exchange rate of US Dollar (USD) relative to Euro is $1.41/E, it means that 1.41 units of USD have to be exchanged for one unit of Euro. Thus, it is said to be the relative price of currencies. There are two types of exchange rates, namely, real exchange rate and nominal exchange rate. While nominal exchange rate is solely a measure of the quantity of one currency to be exchanged for another, real exchange rate is a product of the nominal exchange rate and the relative price level in the domestic and foreign markets. (Eicher, Mutti and Turnovsky, 2009, p.356) Since real exchange rate takes into account the price levels in the domestic and foreign markets, it is the measure of the relative competitiveness of goods and services for two countries. Hence, it is primarily used in the analysis of international trade, imports and exports between countries.

As evident from the definition of exchange rates, they play a vital role in the determination of trade relations between countries since they are established standards of exchange of two currencies. Their greatest relevance is in the field of export and import of goods and services. A hike or fall in exchange rate expresses itself by a decrease or increase in the competitiveness of commodities and services of a country. Since Globalization has integrated the economies of all countries together, exchange rates also play an important role in the maintenance of stability in the domestic economies of various countries and the in the global economy as a whole. Thus, exchange rates are required to be stable or at least, vary with uniformity, thereby ensuring predictability in their values. This predictability of exchange rates was a common feature of the Bretton Woods System but thereafter, the degree of predictability has altered with the passage of time.

Predictability of Exchange Rates before and after the Bretton Woods Era:

The Bretton woods System was an agreement between the major countries to follow a rate of exchange in trade, based on the value of gold. In 1936, the main standard of exchange that existed was the Dollar-Gold standard. Since the Dollar was externally convertible, all other countries pegged their currencies to the Dollar. This arrangement formed the basis for international trade between countries. However, the successive devaluation of the Dollar relative to the value of gold, in 1971 and 1973, followed by the Nixon administration led to the origination of inflationary tendencies in the economy. The inflationary trends in US affected the countries that had pegged its currency to the Dollar, as well and the devaluation of the Dollar created adverse terms of trade for them. Side by side, the external convertibility of the Dollar was suspended. The final outcome was a disagreement between the US and its major trading partners over these two issues and resultantly, the Bretton Woods System that had been a source of exchange stability, collapsed in the year 1978. (Bordo and Eichengreen, 1993, pp.605-608)

The fall of the Bretton Woods System of fixed exchange rate in 1978 and the simultaneous adoption of floating exchange rates raised concerns in international monetary institutions, government of countries and economists about the “the instability in exchange rates of major currencies” which created an atmosphere of uncertainty and “had adverse effects on the rate of investment and economic activity”. (Rana, n.d., p.1) The fall of the pegged exchange rate saw a fall in the predictability of exchange rates which had aided in escalating investment and gains from trade in the Bretton Woods era, by a reducing exchange rate riskiness. There was high volatility observed in the short-term exchange rates in succeeding years similar to equity and commodity markets. The magnitude of gains and losses from trade became more and more erratic, in the absence of proper rules and regulations in the exchange markets. (Bordo and Eichengreen, 1993, p.515)

Today, 23 years since the breakdown of the fixed exchange rate system under Bretton Woods, there are negligible evidences of the stable exchange rate that prevailed under the Bretton Woods system. Ideally, under the Flexible Exchange rate regime, the exchange rate of a currency is an indicator of its economic health. Thus, intervention in the currency market, unless absolutely necessary, is advised against for the maintenance of stability and predictability in exchange rates. However, there are windfall gains to be made by maintaining one’s currency at a low value. Even though devaluations decrease domestic demand, it boosts exports to overseas market. The overall result is a tremendous trade surplus and a high rate of economic growth. Thus, competitive devaluations and regular interventions have evolved as the order of the day. The economies of Japan, China, Korea, are all manifestations of export-led growth. The ultimate consequences are inflation, unfair competition and an abrupt fall in stability and predictability of exchange rates. (Kegley and