Forex: Introducing the Band Proposal

The 'band' proposal would merely widen the permissible limits of exchange fluctuation under the existing system.

Thus, exchange rate changes would do part of the adjusting to changes in the international economy.

Indeed, if such changes were small, exchange rate changes would absorb the entire adjustment. For drastic, or persistent, national divergencies, the rate would move to the lower or upper limit, and international reserves would then be lost or gained to keep the currency within the band.

The proposal to widen the 'ban of fluctuation' is in conception not new; it parallels proposals to widen the gold export-import points under the gold standard.

A considerable number of economists have proposed a widening of the existing two percent band under the IMF system as a useful and rather innocuous means of achieving more exchange rate flexibility.

In addition, the Joint Economic Committee of the U.S. Congress has given favorable airing to the 'band' proposal.

Although it has not specifically recommended adoption of the proposal, it has directed that the administration carefully consider the merits as well as the disadvantages.

For example, and advantage in controlling international capital movements is claimed. If capital flows among nations in search of higher interest rates, it is likely that the foreign investors are hedging their currency transactions in the forward exchange market.

If this is the case, it is the covered interest rate differential, i.e., the interest differences between countries minus the discount (or premium) on forward foreign exchange, which includes the capital flow.

The discount or premium on forward foreign exchange can be influenced by official sales or purchases of forward foreign exchange.

This, in turn, changes the 'covered' interest rate differentials which influence the capital flows.

Under present circumstances, where the limits of exchange rate are one percent on each side of par, the price of forward exchange cannot be pushed past the limits for spot exchange since the buyer could wait and buy spot exchange at a future date for that price.

Thus, the width of the band effectively limits the ability of a central bank to influence the forward discount or premium, ad hence, the covered interest differential.

With this limit, sizable interest differentials cannot be offset, and the ability of the central bank to influence capital movements is also retarded.

With a wider band, a greater interest differential could be offset, thereby allowing more freedom for a country to influence capital movements without altering its own domestic interest rates.

This, of course, is no different from the situation under completely flexible exchange rates except that there is a limit imposed on the degree of fluctuation.

A more basic difference is that par values are still managed for currencies. These would govern all dealings with the IMF and perhaps even all official dealings between countries.

It offers an effective and automatic substitute for the adjustable peg--- within the limits imposed--- without giving up the concept of the peg.

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