although, assuming that monetary policy in the country of the anchor currency is conducted responsibly, extremes of hyper - inflation or deflation will be avoided. both regimes may be prone to fluctuations in interest rates in response to shocks, but with inflation targeting, which requires a flexible exchange rate even if managed to a degree, the central bank has a measure of discretion in the magnitude and timing of its response, whereas, with a fixed rate, defensive reactions must be more immediate and may hence be potentially sharper. hong kong context recent criticisms of hong kong's currency board have focused mainly on two aspects - the implications for the competitiveness of hong kong vis - a - vis other economies and the problems of living with falling price levels. the remainder of this paper is directed mostly at these issues. competitiveness changes in competitiveness are typically measured by comparing movements in some appropriate measure of costs or prices at home and abroad, and adjusting for shifts in exchange rates. the measure of competitiveness thus produced is commonly referred to as the real exchange rate. a stronger real rate means higher relative prices and therefore implies weaker competitiveness. i detect two common misconceptions about the real exchange rate. influencing the real rate the first is the belief that the real rate is amenable to control by the central bank or government and that the chosen regime for the nominal exchange rate is therefore an important determinant of the real rate. let me explain what i believe to be some flaws in this view. even if the central bank could, through intervention in the foreign exchange market or actions to influence domestic interest rates, fix the nominal exchange rate at some particular level, and even if it succeeded in fixing not simply the bilateral rate but the trade - weighted rate, this would only determine the real rate for the short term. this is because any monetary policy actions, such as exchange market intervention or changes in interest rates, in due course have a feedback effect on domestic inflation. more specifically for example, depreciation tends to raise prices. in a market - based economy the central bank, if it already uses monetary policy to set the nominal exchange rate, cannot separately control inflation. eventually any initial gain in competitiveness from depreciation is offset by the inflationary feedback, most obviously so in highly import - dependent economies such as hong kong. empirical studies do not reject the hypothesis that this feedback is eventually 100 %, although the full offset may occur only after a considerable lapse of time. meanwhile the real

mr. reddy reports on the dilemmas of exchange rate management in india inaugural address by the deputy governor of the reserve bank of india, dr. y. v. reddy, at the xith national assembly forex association of india held in goa on 15 / 8 / 97. i am thankful to the organisers of the xith national assembly of the forex association of india for giving me an opportunity to share with you the dilemmas that we face in foreign exchange management. the fifty years since independence have seen significant changes in our exchange rate regime. the exchange rate policy has evolved from the rupee being pegged to the pound sterling until 1975, pegged to an undisclosed currency basket until 1992 and after a year's experience with dual exchange rate system to a market - related system by march 1993. this has helped to bring about flexibility in exchange rate management. a couple of years ago, my predecessor, distinguished dr. s. s. tarapore, addressed this assembly on some of the burning issues of foreign exchange markets. last year, my colleague, mrs. usha thorat gave an authentic and analytical account of the recent developments in forex markets and on the role of authorised dealers ( ads ) in forex markets. today, i will address the dilemmas that we, as policy makers, face in the conduct of exchange rate policy. international parity 2. i will briefly, as a backdrop, revisit the four parity conditions, that you are familiar with. first, the purchasing power parity ( ppp ) which links the spot exchange rate and inflation. secondly, the international fisher relation which links interest rates and inflation. thirdly, the foreign exchange expectations which link forward exchange rates and expected future spot exchange rates. fourthly, the interest rate parity, which links spot exchange rates, forward exchange rates and interest rates. the four parity relations could be combined in several ways to throw light on the four critical variables that are often used in exchange rate management policies, viz., the interest rate differential, the inflation differential, the forward discount / premium, and the exchange rate movement. the theories built around the parity relations help us to understand the foreign exchange markets better, but, they rarely give us ready - made solutions to the problems that arise in day - to - day, say, minute - to - minute operations in the exchange markets. 3. what could be the explanation for such a phenomenon? in the real world, expectations cannot be