ABSTRACT
In principle government policy may influence the spot rate by altering domestic interest rates or by influencing the expected spot rate or the forward rate. However, we can greatly enhance our knowledge of the impact of monetary policy on the spot exchange rate by analysing the 'modern theory' and Cambist views of the forward rate. In the 'modern theory' the forward rate is a weighted average of the interest parity forward rate and the expected spot rate. It turns out that if the response of arbitrageurs to the (riskless) return to investing in foreign assets is high, then government intervention in the forward market will lead to substantial capital flows in the spot market. Hence, forward intervention is useful under a fixed exchange rate regime to stem a capital outflow. On the other hand, if the arbitrage response is large, a rise in domestic interest rates will not lead to large arbitrage spot capital flows. Large speculative flows in the spot market are then required to stem any capital outflow. The forward market is not simply interesting per se, but because of the possible use of forward intervention by the authorities to support the spot rate. This method of support for the spot rate does not require a rise in domestic interest rates and was frequently used by deficit countries under the Bretton Woods system when they faced a speculative outflow on the capital account. In the final part of the chapter we discuss the bankers' or Cambist view of the forward market. This analysis suggests that non-bank covered arbitrage transactions do not lead to net capital flows in the spot market and the latter therefore result purely from speculative activity.
