Exchange Rate Volatility – Can Central Banks Really Help?

The domestic liquidity conditions are driven chiefly by autonomous factors such as currency in circulation, government cash balances and foreign exchange flows. While currency in circulation and government cash balances have a bearing mostly on domestic liquidity conditions and ultimately on interest rates, foreign exchange flows are also expected to have an impact on the exchange rate and the real economy. In the modern globalized world, volatile capital flows pose significant challenges to liquidity management and the conduct of monetary policy. This pushes central banks to maneuver the flow of foreign currencies into market in a bid to neutralize the undesired impact and retain monetary control. However, in closely inter-connected economies of the world, the operations of the central banks in the open market to stabilize exchange rates in the case of excessive inflows or outflows are frequently seen as ineffective. The central banks still intervene and at times have a cost which can be justified only when effectiveness of such intervention could be established clearly. The objective of this research paper is to analyze whether central banks, particularly in developing economies - with special reference to the Indian central bank -intervene enough to bring about any desired level of exchange rates or to moderate their volatility, or they remain ineffective by and large in view of the volume and velocity of the capital flows.