During a recent staff meeting at LeBoeff Financial Capital Inc., Joe Hardy asked the firms in-house economist, Robin Heathers, to provide a discussion of the Federal Reserves (the Feds) intervention in the foreign exchange markets. At the meeting, Heathers made the following statements: Statement 1: If the equilibrium dollar-rial exchange rate fluctuates between 150 rial/USD and 180 rial/USD and on average is 165 rial/USD , then the U.S. Fed can reduce exchange rate volatility by buying rials when the rate moves above 175 and selling rials for dollars when the rate moves below 155. Statement 2: If the average equilibrium exchange rate moves from 165 rial/USD to 175 rial/USD, the U.S. Fed can intervene in the currency markets to return the equilibrium rate to 165. Are statements 1 and 2 as made by Heathers regarding the Feds intervention in the foreign exchange market correct? Statement 1 Statement 2 A) Incorrect Incorrect B) Correct Incorrect C) Incorrect Correct D) Correct Correct Your answer: A was incorrect. The correct answer was B) Correct Incorrect The Fed can intervene in the foreign exchange market. The primary reason the Fed would do so is to reduce exchange rate volatility in the short run. So, statement 1 is correct. However, if the underlying equilibrium rial/USD exchange rate increases from 165 to 175, the Fed cannot maintain the exchange rate at 165 rials/USD indefinitely. To do so, the Fed would have to sell dollars and buy foreign currency each day. The Fed would simply be accumulating rials. Eventually, the Fed would have to abandon any attempt to keep the exchange rate at a level different from the long-term equilibrium rate of 175. My doubt :- shouldnt the strategy given in the first comment be reversed…that is Fed should sell Rials when the rate goes above 175 and buy when the rate goes below 155…? when it sells rials the excess liquidity of rials will bring the rate down to the equilibrium… Am I missing something?
you are missing the fact that in order to reduce volatility the fed would buy rials when they are cheap and sell when they are expensive
nimita02 Wrote: ------------------------------------------------------ > > My doubt :- shouldnt the strategy given in the > first comment be reversed…that is Fed should sell > Rials when the rate goes above 175 and buy when > the rate goes below 155…? when it sells rials > the excess liquidity of rials will bring the rate > down to the equilibrium… Am I missing something? No. As the exchange rate move closer to 180 the dollar is appreciating. To make the exchange rate drop you would need to sell dollars in exchange for rials. This will increase demands for rials and increase supply for dollars. Simultaneously pushing the price of rials up and the price of dollars down.
oh okay… got the point that we havve to think from dollar perspective first… thank u guys…