(24-04-2012, 01:26 PM)freedom Wrote: [ -> ]to make the exchange rate centered monetary policies to work perfectly, I think, one condition is that the trade should be well balanced, that is, money will come in and money will go out. If aggregated money flow towards one direction for a persistent long period, the balance will be completely broken, which can easily cause catastrophic disaster. that means, if previously money is flowing in and you counter by appreciating the currency, it will cause more money coming in(Is now a perfect example of this?). and if previously money is flowing out and you counter by depreciating the currency, it will cause further money outflow(I think 1997 AFC is a good example).
not advance economy trained, my own speculation only. please correct me if i am wrong.
you are right in this way. A country that chooses exchange rate will have to make a choice between allowing free capital flow or controlling interest rate.
However, appreciation does not attract capital inflow, only if the currency is expected to appreciate then will capital flow in.
USD has been depreciating not just because of QE 1 and 2 but people is expecting a QE 3 which will cause USD to depreciate further. As US chooses free capital flow and interest rate, it will not be able to fight against its depreciating currency. Yes, it can try, but it will require strong foreign currency reserve to defend against. Even if a country like Singapore has strong reserve, it will not want the reserve to be eroded as it is meant for the raining day.
Capital flow is determined by various factors of which interest rate is one of the main reason.
For e.g. 1 USD is 1.25 SGD currently, but USA has an interest rate of 5% while Singapore's interest rate is 2%. The right thing to do will then be to sell SGD to buy USD to take advantage of this higher interest rate. This will then cause USD to appreciate as there is higher demand for USD and higher supply for SGD. Thus if Singapore wants to restrict capital flow, it will then have to use interest rate policy to counter this difference in interest rate.
Person A and B with 100 USD and 125 SGD respectively. Using same forex rate, but that Singapore and USa have same interest rate of 2% for easier understanding. If forex changes to 1USD is to 1.2 SGD as SGD appreciates, then person B will now be tempted to change its 125 SGD to USD as he can now earn 2% on 104.1 USD. The USD can also allow him to purchase 104 pens instead of 100 pens earlier on, given that 1 pen is worth $1. If Singapore wants to curb this outflow, it will then have to raise its interest rate. And to curb capital inflow, they have to use interest rate policy to lower interest rate and not to increase interest rate.
Currently, it is due to uncertainty in EU and US that causes capital inflow into Asia and emerging market. As growth is expected to be higher in these market, capital will flow in to take advantage of the difference in growth.
What happen in 1997 is as a result of choosing free capital flow and a fixed exchange rate. Thailand has been growing before that due to huge influx of hot money and FDI. As the bubble starts to burst, capital outflow increases and Thai Baht suffers depreciative forces of which it tries to buy up Thai Baht due to its fixed exchange rate. At the same time, they try to use an interest rate policy to try to curb free capital flow as they do not have sufficient reserve. THis proves to be useless and Baht eventually falls.
The lesson from 1997 is not the need to curb capital flow but that if a country chooses to have a fixed exchange rate, it needs to have sufficient foreign currency reserve to prevent such an attack. This means more trade surplus
As for why interest rate policy is less effective in Singapore, I have already mentioned main reasons like inactive secondary bond market, high saving rate, high import percentage and banks with strong balance sheet.