Exchange market pressure

Exchange market pressure: Theoretical Foundations

Exchange market pressure: Practical Issues

Exchange market pressure: Advantages and Problems

Foreign exchangemarket pressure (EMP) indexes are weighted schemes of variables designed to gauge speculative pressure on a country’s currency. These variables normally include the exchange rate, the domestic interest rate, and/or a measure of international reserves available to the monetary authority. Crisis incidents in recent years, including the severance of the British pound from the exchange rate mechanism in 1992, the Asian crisis in 1997, and the abolition of the Argentinean peg with the U.S. dollar in early 2002, have shown that the potential for foreign exchange market pressure to result in currency crises is significant, and hence monitoring informative variables is crucial.

Investors may put downward pressure on a currency for several reasons: for example, theymay have spotted a fundamental imbalance and believe that a given exchange rate is unsustainable; or they may observe and follow the actions of other investors/ speculators. The reaction of policymakers depends on whether they want to accommodate the pressure and allow devaluation or, assuming a tough stance, they prefer to deter it. If the latter is the case, theymay increase the short-terminterest rate (hence offering a greater return than before on domestic currency investments) or spend international reserves (buying the domestic currency in the foreign exchange market with the aim of supporting its value). An EMP index is designed to capture this kind of activity in the foreign exchange market.

See also balance of payments; capital controls; contagion; currency crisis; earlywarning systems; EuropeanMonetary Union; exchange rate regimes; exchange rate volatility; foreign exchange intervention; interest parity conditions; international reserves; monetary conditions index;money supply; speculation; spillovers; sterilization

FURTHER READING

• Eichengreen, Barry, Andrew Rose, and Charles Wyplosz. 1995. ‘‘Exchange Market Mayhem: The Antecedents and Aftermath of Speculative Attacks.’’ Economic Policy 21: 251 98. Interest rates are incorporated for the first time in the definition of the foreign EMP index. 
• Girton, Lance, and Don Roper. 1977. ‘‘A Monetary Ap proach of Exchange Market Pressure Applied to the Postwar Canadian Experience.’’ American Economic Review 67(4): 537 48. Laid the theoretical foundations for the construction of EMP indexes. 
• Kaminsky, Graciela L., and Carmen M. Reinhart. 1999. ‘‘The Twin Crises: The Causes of Banking and Balance of Payments Problems.’’ American Economic Review 89 (3): 473 500. Uses a measure of EMP in order to assess an early warning system. 

ALEX MANDILARAS