The financial markets are a key component of the economy of a country. Thus, it is not surprising that decisions taken by the government of a country and its central bank have major consequences for the working of such markets. Activities in a country's domestic financial markets are related to activities in foreign markets as well. Thus, decisions taken in one country invariably have implications for the financial markets of other countries.

The policies of significance for a country's financial markets are the fiscal and monetary policies designed and implemented by the federal government and the central bank, respectively. An economy's interest rates, which influence all decisions of significance, are determined by such policies. Trade with foreign countries, foreign investments in the domestic economy, and a country's investments in foreign economies are also influenced by such policies.

ECONOMIC GROWTH

Economic growth is a measure of the expansion of an economy over time. It is measured by comparing the output for a period, such as a year or a quarter, with the output of the previous period.

Output in an economy is referred to as the gross domestic product or GDP. We will define the GDP shortly, as well as a related measure known as GNP or gross national product. Considering that inflation is a constant feature in life, GDP will increase over time even if the real output remains constant. Consequently, the standard practice is to measure the GDP for a year using the price level of a base year.

GROSS DOMESTIC PRODUCT

GDP is a measure of the output of a country within its borders. The output could be on account of economic activities carried out by its nationals, or by foreign nationals operating in the country. The output refers to the final output, and intermediate products are not counted, for the final output subsumes the same. For instance, assume that a product sold in the market is made by using products X, Y, and Z. The price of the output will reflect the cost of the inputs. Thus, while measuring the GDP for a year, the value of the output is considered and the cost of the inputs is not, for it would amount to double counting.

GDP is determined by the aggregate demand in an economy. The term aggregate demand refers to the demand for goods and services in an economy. The greater the aggregate demand, the greater will be the induced production, and consequently the higher will be the GDP.

The aggregate demand can be divided into the following sectors:

• Consumption
• Residential investment
• Capital expenditure by the corporate sector
• Government spending
• Inventories
• Foreign trade

GDP VERSUS GNP

GDP measures the output by the residents of a country within its borders, while GNP measures the aggregate output of the nationals of a country, no matter where they are located.

Let us take a country like the United States. Assume US nationals based in the country generate 400 billion dollars of output, while foreign nationals present in the United States generate 300 billion dollars of output. We will say that the United States has a GDP of 700 billion dollars. Assume that US nationals based in the EU generate 150 billion dollars of output while those based in Japan generate 100 billion dollars' worth of goods and services.

We will say the United States has a GNP of 700 + 150 + 100 – 300 = 650 billion dollars. It should be noted that the 150 billion produced by US residents in the EU will constitute a part of the GDP of that bloc of countries. Similarly, the 100 billion output produced by US residents in Japan will form a part of Japan's GDP.

GDP and GNP do not take into account the wear and tear of capital goods. By making suitable adjustments for the depreciation of capital goods, we can compute the net domestic product (NDP) and the net national product (NNP).

All the outputs generated in an economy are not necessarily destined for the market. For instance, a country may produce a significant amount of products for the use of its defense forces. This will definitely constitute a part of its GDP, even though it is not destined for the market.

Certain productive activities are not reflected in a country's GDP. For instance, the household sector generates a significant level of output, which is consumed within the family of the producer and not intended for sale. Consequently, it will not be reflected in the country's GDP. Many developing countries have a thriving parallel or underground economy. Such economies may generate significant output. However, for obvious reasons, the output cannot be estimated and included in the country's GDP.

Certain types of output are not included while computing GDP and GNP. Securities transactions, for instance, do not count. Thus, if Alex sells 100 shares of Apple to Andrea, it will not be a part of America's GDP. Social welfare payments and assistance programs do not count. They do not represent a productive activity, for all that the government is doing is taxing Peter to pay Paul. Similarly, certain property transactions are included while others are not. Assume that you build a house worth 500,000 USD in Nashville this year. It will be accounted for while computing America's GDP for the year. If you sell that property to someone three years later for 650,000 USD, it will have no consequences for the GDP in that year.

INFLATION ADJUSTMENT

GDP is based on the current price level in an economy. Inflation, or a steady increase in price levels over the years, is a fact of life in most countries. Thus, even if the real output of an economy were to remain constant, the nominal GDP will increase due to higher prices. Consequently, the GDP level for a year needs to be deflated to facilitate comparisons across years. In practice one year is designated as the base year and its price level is typically assigned a value of 100. Assume that this year's price index is at 125. This year's nominal GDP is 640 billion dollars. The real GDP is (640 × 100) ÷ 125 = 512 billion dollars.

TRANSNATIONAL COMPARISONS

The GDP of a country is typically denominated in its own currency. Thus, an adjustment is required while comparing output levels across countries. The standard practice is to compute the GDP of every country in US dollars, and then compare.

To convert a country's GDP into a dollar value, we can use either the market exchange rate for that currency or what is called the Purchasing Power Parity (PPP) rate of exchange. The PPP rate measures the price of a standard product in a country vis-à-vis its price in the United States.

For instance, assume that India's rupee is currently being quoted at 75 per USD. Thus, if Indian GDP is 5,625 billion rupees, the equivalent amount in USD will be 75 billion dollars. Assume, however, that a pair of Levi's that costs 25 USD in the United States costs Rs 1250 in India. The PPP-based Rupee-Dollar exchange rate is 50 rupees per dollar. Hence, India's GDP in dollar terms, as computed using a PPP-based exchange rate, is 112.50 billion dollars. In practice, for many emerging economies there can be a significant difference between the market rate of exchange and the PPP rate.

THE BIG MAC INDEX

It has been argued that one of the most standard products in the world is the McDonald's Big Mac burger. Consequently, it has been recommended that the prices of burgers be compared across countries to arrive at the PPP exchange rate. For instance, if a burger that costs 1.50 USD in the United States were to cost Rs 60 in India, the PPP exchange rate will be 40 rupees per dollar.

INFLATION

A booming economy, which signals an economy in heat, will invariably be accompanied by a high level of inflation. Inflation, of course, refers to the change in price level over time. For instance, if a product that cost $100 last year, were to cost $108 this year, we will say that the inflation is 8%. Inflation steadily erodes the purchasing power of money.

A well-known result in economics is the Phillips Curve, which states that the rate of inflation and the level of unemployment are negatively related. Thus, if inflation is high, unemployment will be low and vice versa. Let us analyze the reason.

If an economy is working at close to full capacity, the factors of production would be utilized close to their maximum. Thus, unemployment will be very low. If capacity has to be increased further, it would invariably result in the poaching of labor from other producers. The employees who opt to shift will demand higher wages. If they opt not to shift, they will demand higher wages from their present employers. Rising wage levels will push up the cost of production. Producers will pass on the greater input costs to their consumers. The net result is an increase in price levels across the board, or inflation.

Now consider an economy that is in the throes of a recession. There will be severe layoffs and unemployment will be high. Aggregate demand, however, will be low on account of depressed economic conditions. Price levels will therefore be low, as reflected by low inflation, or possibly even deflation.

A similar analysis can be done for the other major factor of production, namely capital. If multiple entities are vying for scarce capital, the provider of capital will hike the cost or the rate of interest. This too will push up the cost of production, as most companies rely on debt capital to fund the bulk of their operations. Once again, the net result is inflation.

An increase in the cost of labor and capital need not be the sole reason for inflation. In an economy that is doing well, consumption levels are likely to be high. Supply, however, may be unable to keep pace with burgeoning demand. The net result will be an increase in price levels.

Inflation can be a self-fulfilling prophecy in practice. Assume that the workforce of a country is worried about the specter of inflation. It will demand higher wages and salaries. Producers, if they are compelled to concede the demand, will increase the prices of their outputs. Thus, in this case, the worry about inflation has manifested itself in the form of inflation.

Certain extraneous factors may lead to inflation. For instance, OPEC may suddenly decide to cut down the production of crude oil. Oil prices will rise, and will simultaneously pull up the prices of other goods. Or the United States may get involved in a war in an Asian country. This will cause the United States to crank up defense production, and resources could be diverted from civilian to defense uses. The net result could be an increase in price levels.

Why should a policymaker be perturbed by a high inflation level? Corporate expenditure decisions depend on the cost of capital and labor, and on the price of the outputs. High inflation corrupts the decision-making process, for a planner can have faith neither in the prices of the inputs, nor in those of the outputs. Consequently, businesses in such situations have a tendency to postpone capital expenditure that is required to expand, grow, or diversify. This will obviously have consequences for the GDP of a country.

TYPES OF INFLATION

Inflation may be of several types. These are:

• Demand Pull Inflation
• Cost Push Inflation
• Market Power Inflation
• Full Employment Inflation

Demand pull inflation arises in situations where the demand for goods and services outpaces the supply. If credit is easily available, there will be higher demand. Producers may not be able to cater to the growing demand immediately. This will lead to a situation where too much money is chasing too little goods, and the net result is inflation. There is another dimension as well. Reacting to greater demand, producers will increase their demand for the factors of production such as land, labor, and capital. Wage levels and interest costs will rise, leading producers to hike the prices of their output. The consequence, once again, is inflation.

The lack of adequate domestic supply could also lead to greater imports into the country. This will increase the demand for foreign currencies and the local currency will depreciate. This will stimulate exports and reduce imports.

Cost push inflation refers to a situation where the cost structure for producers increases, causing them to hike their prices, even in a situation where demand is stable. For instance, consider a product whose price depends heavily on the price of crude oil. If oil-producing countries cut their output, oil prices will rise, leading to a higher cost of production. We have seen that the Phillips curve predicts that inflation and unemployment are negatively related. Thus, when the economy is booming, inflation should be high and unemployment should be low. In a recession, however, unemployment should be high and inflation levels should be low. But there have been situations where both unemployment and inflation have been high. This is termed as stagflation. This happened in the United States in the 1970s and 1980s. The cause was a rapid increase in oil prices. Since the United States was largely dependent on imported crude oil, US producers saw a significant rise in their input costs, forcing them to hike prices. Stagflation is a manifestation of cost push inflation.

Market power or profit push inflation refers to the ability of monopolist producers to hike product costs because they know that consumers do not have an alternative. For instance, Microsoft has a virtual monopoly when it comes to products like MS Office and Windows. Consequently, the company can hike its prices, knowing well that demand is unlikely to be affected.

Wage spiral inflation is a type of market power inflation. In certain countries, trade unions have a lot of political clout and can repeatedly negotiate wage increases with producers. The latter will, after a certain stage, have no alternative but to pass on the increased cost to consumers. The net result is inflation.

Full employment inflation refers to a situation where an economy is operating at full capacity to cater to a high demand level. Producers will have to pay more for inputs such as labor and capital. One way for the government to arrest the increase in price levels in such situations is by encouraging imports. This can be done by reducing customs duties. An inflow of imports will lead to an increased demand for foreign currencies and cause the local currency to depreciate. This will have a positive impact on exports, which once again could push up domestic prices, which had been controlled to an extent by increased imports.

As we have discussed earlier, the fear of inflation can lead to inflation. Anticipating a higher rate of inflation, labor may demand higher wages. Suppliers will factor this into their products costs, which will boost the prices of their outputs. Thus, anticipated inflation may lead to higher actual inflation. This is termed as expectation inflation, for obvious reasons. This kind of inflation can spiral out of control.

INTEREST RATES

Interest is the price of money. People who are willing to postpone current expenditure, the surplus budget units (SBUs), lend to those whose current consumption needs are in excess of their available resources, the deficit budget units (DBUs). The equilibrium interest rate will be such that the supply of capital equals the demand for capital. Interest is the rent paid by the borrower of capital to the lender. For, while the former is using the capital, the latter, to whom it belongs, is deprived of the opportunity to use it himself.

In a recession, unemployment will be high. Insecure people will typically save more. Entrepreneurs are likely to borrow less for capital expenditure purposes. As a consequence of high supply and low demand, interest rates are likely to be low. The prevailing rate of inflation is likely to be low and consequently the inflation risk premium, a key component of the interest rate, will be low.

On the other hand, when an economy is booming, consumer confidence will be high and people will borrow more to spend. Thus, the market for consumer loans will be buoyant. In the prevailing euphoric environment, producers are likely to spend more on capital expenditure. The household sector will save less and spend more. On account of high demand and low supply, interest rates will rise. Worried by the prospect of rising interest rates, lenders will demand an even higher interest risk premium. This will further push up interest rates.

THE FEDERAL BUDGET DEFICIT

The federal or central governments of most countries rely on deficit financing. That is, they spend more than what their revenue in a financial year would warrant. The deficit is reflected by borrowing. In recent years, many legislatures have put a cap on the fiscal deficit as a percentage of a country's GDP. This has helped rein in deficit financing to an extent. The amount of debt outstanding for a sovereign government is called the public debt of the country.

Deficit financing can lead to a debt trap. A growing debt level implies an increasing interest rate bill for the federal government. Also, the existing debt has to be paid off in tranches. Thus, to service past debt, a country may need to borrow more and so its public debt will rise. In such a situation, a country may be borrowing to service past borrowings, and not to fund current productive economic activities.

A federal government has three sources of loans. It can borrow from within its borders, from other countries, or from supranational organizations like the World Bank and the International Monetary Fund.

To service debt a government has three options. It can stimulate economy activities, which, if successful, will lead to higher tax revenues, enabling it to pay its lenders. It can hike the tax rates; however, hiking tax rates need not always result in greater revenue for the government. In response to a hike in taxes, a producer may scale back on its operations, or migrate the business activity to another country. A third option is what is termed as debt monetization, or the printing of additional money. This option can give rise to an inflationary spiral in practice.

The budget deficit is correlated with the state of the economy. If the economy is booming, people are less likely to depend on social welfare payments. This brings down the expenditure for the government. Also, in such an environment, tax revenues are likely to be high. On the other hand, when the economic conditions are depressed, social welfare payments will be high and tax revenues are likely to be low. In addition, to kickstart the economy in such situations, governments will step up on capital expenditure. These factors will manifest themselves as a budget deficit.

Certain countries like the United States have a major advantage. The US dollar is a globally acceptable currency that people are willing to hold around the world. Consequently, the United States can run up higher deficits than other countries. It must be remembered that an increasing public debt for a country will result in an increase in the rate at which it can borrow. Worried by the increasing debt burden of a country, prospective lenders will be more circumspect and demand higher rates of interest. A situation may come when a country cannot borrow more and it is forced to default. It must be remembered that in practice, one of the main reasons why a government borrows in a particular year is to pay interest and make principal repayments on debt raised in the past.

MEASURES OF BUDGET DEFICITS

We will define three measures of deficit:

• Revenue Deficit
• Fiscal Deficit
• Primary Deficit

The revenue deficit may be defined as the revenue receipt in a financial year minus the revenue expenditure for the same period. If there is a deficit in a given year, it signals that the earnings of the government are inadequate to finance the annual expenditure. The balance has to be met by capital receipts. That is, the government must either borrow or sell some of its assets. To reduce the revenue deficit, a government can cut back on its expenditure and increase its tax and non-tax revenues. A high revenue deficit fuels future deficits. If the deficit is high, the more the government has to borrow. The more a government borrows, the higher will be its future interest rate payments, which will lead to greater revenue deficits in the future.

The term fiscal deficit is the excess of total expenditure, revenue and capital, over total budget receipts, excluding borrowings. Thus, the fiscal deficit is a measure of how much a government needs to borrow in the forthcoming financial year.

There are three reasons why a government may borrow in a financial year. First, to repay principal on past debt issues that are now maturing. Second, to fund the current revenue deficit. Third, to pay interest on debt issued earlier. A government may attempt to bridge the fiscal deficit by borrowing from domestic sources. This option will not lead to an increase in domestic money supply, which would tend to be inflationary. An alternative is deficit financing. The central bank will buy debt securities from the government by printing fresh currency. This will obviously lead to an increase in money supply and can trigger a bout of inflation.

A fiscal deficit does not necessarily mean poor economic management. If a government borrows to create capital assets that will benefit the country in future years, there is nothing negative about it. If, however, a country incurs larger and larger revenue deficits, and keeps borrowing more just to cover them, then this is not a desirable situation.

THE PRIMARY DEFICIT

This is defined as the borrowings for the current year minus the interest payment on account of past debt issues. If the primary deficit is zero, it means that the entire borrowing for the year is to meet interest expenses on account of debt securities issued in the past. If the primary deficit is positive, however, it means that the government is borrowing to fund expenditure or to repay past debt.

FISCAL POLICY

The term fiscal policy refers to the expenditure policy of a government and its tax policies. If an economy is in a recession, one way of boosting it is by cutting corporate and personal tax rates. A reduction of the former will increase the profit margins for the producers, which will stimulate them to make fresh investments. If personal tax rates are lowered, consumers will have more spending power and will seek to acquire more goods and services. Both factors will cause the economy to revive. Economic spending by both the business and household sectors has a cascading effect. This is because one party's expenditure is another party's income.

An alternative tool for governments is to increase spending on government-funded infrastructure projects. This too will increase aggregate demand, and can cause an economy to recover by having a cascading or multiplicative effect.

In practice, fiscal policies may offer a government little room for tackling an economy that is slowing down. If the fiscal deficit is high, and particularly when there is a cap on the fiscal deficit, it may not be possible for a government to spend more on capital expenditure. And given the existing deficit level, reducing tax rates will further bring down revenues, and is not an option, either.

BUDGET DEFICITS AND THE CAPITAL MARKET

If the federal government has a high budget deficit, it will lead to an increased demand for capital, which will serve to increase the cost of capital for all players in the market. This will increase the cost of doing business in a country, and will lead to a reduction in capital investments. Also, for a given availability of capital, an increase in the demand for funds by the federal government would mean that there is less capital available for the private corporate sector. This is termed as the crowding out effect.

THE ROLE OF THE CENTRAL BANK

The central bank, such as the Federal Reserve in the United States and the Bank of England in the United Kingdom, implements what is termed as monetary policies. In the United States, the Federal Reserve targets what is called the Federal Funds or Fed Funds rate. This is the rate at which banks borrow from each other. The other options available to the Fed to control the economy are open market operations and the reserve rate.

Open market operations refers to the buying and selling of government securities by the central bank to influence money supply, and consequently interest and inflation rates. If a central bank wants to increase the money supply, it will acquire government securities from the market. This will increase the money supply. Because the supply is increasing, the price of money, or the interest rate, will decline. Lower interest rates will push down the cost of both consumer and corporate credit and help stimulate the economy.

On the other hand, if an economy is overheating, the central bank will sell government securities and suck money out of the economy. The reduction in money supply will cause interest rates to rise. Companies will cut back on capital expenditure and consumers will spend less. This can cause a heating economy to cool down.

The reserve rate is the percentage of deposits that a commercial bank has to maintain either in the form of approved government securities or as a deposit with the central bank. The consequences may be viewed as follows. Banks are dealers in money, and like all dealers have a bid–ask spread. The bid for a bank is its borrowing rate while the ask is its lending rate. A higher reserve ratio means that a bank has less money to lend. As a consequence, it will lower its deposit rates and hike its lending rates. This will lead to a decline in deposits, and in the case of countries that permit capital outflows, to a flight of capital overseas. On the other hand, an increase in lending rates will lead to a reduced demand for capital by potential investors. This could impede fresh capital expenditure and retard economic growth.

Central banks also do repurchase and reverse repurchase transactions with commercial banks. The repo rate is the rate at which a commercial bank can borrow from the central bank on a collateralized basis. On the other hand, the reverse repo rate is the rate at which the central bank borrows from commercial banks, once again on a collateralized basis. If the central bank increases the repo rate, the cost of borrowing will increase for commercial banks, which will resonate throughout the economy. A decline in the repo rate will lead to greater borrowing by commercial banks, and will ease the availability of credit in the market.

BUDGET DEFICITS AND MONETARY POLICY

If the federal government has a high budget deficit, this means it is spending a lot. This will boost aggregate demand in the economy. The central bank, like the Federal Reserve, may judge this as being inflationary, and act to curb the demand for money by hiking interest rates. The resultant increase in the cost of money can arrest the growth in aggregate demand induced by greater government spending, by reducing both consumer spending and corporate borrowing.

CROSS-BORDER BORROWING

Players in the domestic economy can borrow from lenders in foreign countries as well. If interest rates in a country are attractive, foreigners may seek to lend, as the alternative is to lend at a lower rate in their domestic market. However, cross-border capital flows have a foreign exchange risk. Assume a German bank lent 10 million euros to a US entity when the exchange rate was 1.2125 EUR-USD. Assume the loan is denominated in dollars, and that the corresponding principal in dollars is 12.125 million. The loan is for one year, and at the time of repayment the exchange rate is 1.2255 EUR-USD; that is, the dollar has depreciated. If the borrower pays back 12.125 million USD, the amount received by the lender in Germany will be only 9.8939 million. Thus, if an overseas lender denominates the loan in the foreign currency, it stands to lose from a depreciating foreign currency. Of course, if the foreign currency were to appreciate, the lender would stand to benefit.

For both foreign lenders and exporters based in a foreign country, currency risk is a nonissue if the transaction is denominated in their domestic currency. In practice, importers in advanced economies usually have the market clout to insist that the transaction be denominated in their own currency, which puts the exchange risk burden on the exporter.

If a US entity pays back a loan to a foreign lender, there will be dollars in the hands of the recipient. If the receiver opts to sell the dollars to convert the proceeds to their own currency, the dollar may depreciate due to increased supply.

Now consider a situation where a US entity issues dollar-denominated bonds in a foreign country. This will lead to greater availability of capital in the United States, which could bring down interest rates. Because the foreigners are acquiring dollar debt, there will be a demand for the USD, which would cause an appreciation in its value. This will lead to reduced exports out of the United States, and increased imports into the United States. At some stage, if the debtholders decide to sell on a large scale, bond prices will be depressed, which means that bond yields will go up in the United States.

CENTRAL BANKS AND FOREIGN EXCHANGE MARKETS

The term open market operations refers to the buying and selling of government securities by the central bank of a country. The term has another connotation as well. Central banks can buy and sell foreign currencies to arrest the appreciation or depreciation of their home currency.

Assume the US dollar is rapidly appreciating with respect to the British pound and the euro. The Federal Reserve may buy these currencies. This will increase the supply of dollars and help control its appreciation. If the dollar stops appreciating, imports into the United States will come down and exports from it will increase. This will cause greater demand for the dollar relative to other currencies, and may stem the depreciation induced by the central bank. In the process of buying the foreign currencies, the Fed would have injected money into the economy. The increase in the supply of money will bring down interest rates and the price of credit. This will stimulate greater production and may lead to inflation in the medium to long term.

On the other hand, if the US dollar is rapidly depreciating, the Federal Reserve may create demand for the dollar by selling foreign currencies. This will cause the dollar to appreciate. As a consequence, US imports will increase and exports will decline. This will lead to a greater demand for foreign currencies by Americans, and will work to arrest the appreciation of the dollar induced by the central bank. In this case, when the Fed sells foreign currencies, it is reducing the money supply in the domestic economy. This reduced availability of money in the economy will push up interest rates, and can cause the economy to contract due to a higher cost of capital for producers.

STERILIZED AND UNSTERILIZED INTERVENTIONS

As we have seen, foreign currency purchases and sales by a central bank have implications for the domestic money supply. If the central bank acquires foreign currencies, it would have injected money into the economy. On the other hand, if the central bank sells foreign currencies, it would have sucked money out of the economy. Such action by a central bank, without a concomitant action in the money market, is termed as an unsterilized intervention.

There is another option available to the central bank. If it acquires foreign currencies, it can sell government securities and mop up the extra money in the system. On the other hand, if it sells foreign currencies, it can buy government securities and inject money into the system to compensate for the contraction caused by the sale of foreign currencies. This kind of intervention, which requires a compensatory intervention in the money market, is termed as a sterilized intervention.

EXCHANGE RATES

The demand and supply of foreign currencies may best be illustrated by using an example of two countries, say the United States and Japan. The demand for US dollars arises on account of the following factors. Japanese residents may wish to buy US products and services. Japanese investors may wish to acquire securities in the US money and capital markets. Japanese investors may have borrowed in the past in the United States and need to repay principal and/or interest. It should be noted that the demand for US dollars means the supply of Japanese yen. Thus, for all these reasons, there will be demand for the dollar and the supply of Japanese yen.

Now consider the supply of US dollars; the reasons for this supply are the following. American residents may wish to buy Japanese products and services. American investors may wish to acquire securities in the Japanese money and capital markets. American investors may have borrowed in Japan in the past, and need Japanese yen to repay the principal or to pay interest. Thus, the supply of US dollars translates into a demand for Japanese yen.

Left to itself, the market will find its equilibrium. Now assume that there is a technological revolution in Japan and the demand for Japanese products by Americans surges. Assume that the demand for American products by the Japanese is relatively unaffected. The result will be an increased demand for the yen, which means a greater supply of dollars. The yen will appreciate relative to the dollar. The appreciation will stimulate the demand for US goods and services and, to an extent, dampen the increased demand for Japanese products. The market will find an equilibrium exchange rate by itself.

The currency market that exists in practice is what is called a dirty float or a managed float. What we have described earlier is a free-floating market. In practice, central banks intervene in currency markets to nudge the exchange rates in a particular direction. So, if the dollar is rapidly appreciating, the Bank of Japan may sell dollars from its reserves or the Fed may buy Japanese yen from the market. On the contrary, if the dollar is rapidly depreciating, the Fed may sell Japanese yen, or the Bank of Japan may buy dollars.

There was a time when the currency rates were linked to gold and we had what was called the gold exchange standard. Every currency had a fixed value in terms of the dollar, and the dollar had a fixed value in terms of gold. The US government gave an assurance that, on demand, it would freely convert dollars to gold and gold to dollars. There arose a situation when it became obvious that the gold reserves of the United States were not adequate to support the quantum of dollars in circulation. Because the dollar was the central currency, countries other than the United States required large dollar balances to fund their global transactions. This meant that the United States had to run large balance of payment deficits. This implication for a reserve currency is called the Triffin paradox.

When it became apparent that the exchange standard was not sustainable, the major currencies began to float. That is, exchange rates began to be determined by free market forces of supply and demand, subject, of course, to periodic interventions by the central banks.

ISSUES WITH A RESERVE CURRENCY

If the US dollar is the reserve currency, other countries would like to have large dollar balances. This would imply that their exports to the United States should exceed their imports from the United States, which implies that the United States should have a large current account deficit. Historically, the US dollar has been acceptable as a reserve currency for the following reasons. First, both World War I and World War II left the United States virtually untouched. Second, the United States has a large domestic economy that can better absorb shocks and disruptions.

Since the rest of the world runs on dollar balances, the Federal Reserve needs to periodically inject dollars into the economy to keep the global economy well oiled. This will increase the money supply in the United States, which will cause domestic inflation to rise. An increase in domestic inflation will make US exports even less competitive, and will lead to greater imports into the United States.

The United States would like a situation where there is high demand for US dollar–denominated bonds. This will push up bond prices, which means that yields will be pushed down, leading to the availability of cheaper capital. But the higher demand for US bonds will lead to an appreciation of the dollar, which will cause US exports to decline and US imports to increase.

Thus, while it sounds impressive to say that a country's currency is the global reserve currency, the consequences are not always desirable. The central bank of the country whose currency is the global reserve has to walk a tightrope between its domestic stakeholders and its overseas audience.

CROSS-BORDER IMPLICATIONS OF CENTRAL BANK ACTIONS

Today's world economies are interconnected. Assume that the Fed wants to jump-start the US economy by reducing interest rates. American producers will have access to cheaper capital. A decline in bond yields, however, will make US debt less attractive for foreign investors, who will move money from the US market to other capital markets. This will cause a reduction in the supply of capital in the United States. US investors may also decide to bypass the US market and invest in other countries offering a higher rate of interest. Due to higher demand for foreign currencies by retreating foreigners and Americans seeking to invest abroad, the dollar will depreciate and other major currencies will appreciate. This will boost US exports and reduce US imports.

If the Fed were to reduce interest rates, the Bank of Japan may also follow suit. This could lead to capital flight from Japan to a third country. This will cause a reduction in the supply of capital in Japan. The Japanese yen will depreciate, which will offset to an extent the appreciation induced by a depreciating US dollar. Japanese exports to the United States will increase, thereby reversing the decline caused by a depreciating dollar. Japanese imports from the United States will decline, thereby reversing the increase caused by a depreciating dollar.

QUANTITATIVE EASING

Quantitative easing (QE) refers to central banks acquiring government and corporate bonds from financial institutions. The increased demand for such securities pushes up their price, which leads to a decline in yields in the market. This brings down the interest rates in the economy, which stimulates borrowings by both the business and household sectors. As a consequence, this in principle can revive a slowing economy.

Quantitative easing has implications for the stock market and the real estate market. If the central bank acquires debt securities from a financial institution, it will leave money in the institution's hands, some of which may find its way to the stock market, because, as a consequence of lower yields on debt, equity may be perceived as a more attractive investment. Increased demand for shares will push up share prices, leading to an increase in wealth for all shareholders. Some of these shareholders may use their wealth to acquire property, which could boost the market for real estate.

Quantitative easing brings down the cost of debt in an economy, for agents in all three sectors: the government, business, and household sectors. However, there is a flipside. Easy availability of money may lead to higher inflation, because if supply does not keep pace, newly acquired money may end up chasing an existing basket of goods.

If quantitative easing is implemented in the United States, interest rates will come down. This will lead to reduced demand for US dollars by foreigners seeking to invest in the US debt market. This will cause the US dollar to depreciate with respect to the currencies of its trading partners. The net result will be an increase in exports out of the United States and a decline in imports into the country, causing the balance of payments situation to improve.

Once the objectives have been met. the central bank can taper quantitative easing. This will cause interest rates to increase. This will lead to a greater investment in debt securities by both domestic and overseas investors. An increase in interest rates in a country will have ramifications for other countries. For instance, if quantitative easing were to taper off in the United States, portfolio investors may divert investments that were planned for an emerging economy like India, to the United States. The demand for US dollars will increase and the demand for the Indian rupee will decline. Thus, the dollar will appreciate with respect to the rupee. This will boost exports from India to the United States and improve India's balance of trade.

QUANTITATIVE EASING VERSUS OPEN-MARKET OPERATIONS

Quantitative easing leads to an intervention by central banks on a much larger scale, as compared to open-market operations, although both lead to the acquisition of securities by the central bank. The primary focus of open-market operations is to influence interest rates in the economy, whereas the primary focus of quantitative easing is to increase the amount of money in circulation in the economy. In an open-market operation, the central bank primarily acquires short-dated securities from the market. As part of quantitative easing, however, central banks have also acquired medium-term and long-term debt securities. Also, acquisition of privately issued securities may be a part of quantitative easing, a tactic that is absent in an open-market operation.