Exchange Rates and Fiscal Policy

There are many factors that affect exchange rates in today’s complex international business environment. The devaluation of a currency can leave the organizations within that country vulnerable to buy-outs. Additionally, the devalued currency leaves citizens and businesses with reduced purchasing power on the international stage. A weak currency can have devastating effects on the entire economy. Governments have consistently demonstrated the intent to intervene both directly and indirectly.

In an attempt to stabilize currency, governments utilize a variety of techniques to strengthen the value of their currencies. The most important tool that governments frequently adjust is interest rates. According to Madura (2008), the central bank “is likely to focus on interest rates or government controls when using indirect intervention” (p. 171). By adjusting interest rates, the government can encourage the inflow or outflow of currency into the market. Increasing the short-term rate, for example, will encourage funds to remain within the country and thus stabilize a falling currency. In the past, governments have made periodic adjustments to interest rates with measured success. While increasing interest rates encourages investment, it also increases the cost of capital for domestic corporations.

Another tool used by governments is direct intervention of the capital markets. During the Asian crisis of 1997, multiple countries attempted to infuse capital in an attempt to stabilize the falling value of their currency. In addition to adjusting interest rates, these countries invested in their own currency against the dollar. Utilizing money from their reserves, nearly every effort in this regard proved quite fruitless. Market forces, time and time again, were too large for direct intervention to alter.

Perhaps the most unrecognized and under-utilized method of government intervention is in adjusting corporate tax rates. As a method of indirect intervention, the money otherwise dumped from the reserve into capital markets might be better spent by not spending it at all. By reducing the tax burden, stimulus is achieved and foreign investment is encouraged. Governments must consider the wide variety of options available when addressing exchange rates. The stabilization of currency is a perpetual endeavor. According to our Madura (2008), “Several studies have found that government intervention does not have a permanent impact on exchange rate movement” (p. 168). In the end, governments will generally utilize a combination of all of their options.

References

Madura, J. (2008). International Financial Management (9th ed.). Ohio: Cengage Learning


Keyword: management cadre, global economy, international business, exchange rates, economic incentive, foreign investment