Can governments effectively select and implement exchange rate policy instruments by considering the four aspects of coercion, directness, automaticity, and visibility?

To achieve policy objectives that affect people’s lives, governments use policy instruments with different characteristics such as coercion, directness, automaticity, and visibility to stabilize exchange rates, align the interests of economic actors, and pursue economic stability through international cooperation.

 

The government conducts policy by considering the characteristics of policy instruments to effectively achieve the goals of policy, which is the totality of activities that affect people’s lives. Policy instruments have different characteristics in four aspects: coercion, directness, automaticity, and visibility. Coercion is the degree to which the government restricts the behavior of individuals or groups, e.g., regulating the sale of hazardous food is highly coercive. Directness refers to the degree to which the government is directly involved in carrying out and financing public activities. When a government does not carry out a policy directly but contracts out to the private sector to do so, it is less direct. Automaticity refers to the degree to which the government leverages existing organizations rather than establishing a separate administrative body to carry out the policy. Implementing an electric vehicle subsidy program through an existing city hall environmental department is high in automaticity. Visibility is the degree to which the funding to implement a policy is explicitly identified in the budgeting process. In general, adjusting the degree of social regulation does not entail budgetary expenditures and therefore has low visibility.
As an example of the choice of policy instruments, consider the economic phenomenon of exchange rates. The exchange rate, which is the rate at which a country’s currency is exchanged for a foreign currency, converges in the long run to a level that reflects the underlying economic conditions of a country, such as productivity and prices. However, in the short term, the exchange rate can deviate from this. If the exchange rate moves in a different direction than expected, or even if it moves in the same direction as expected, the fluctuations are larger than expected, economic actors may be exposed to undue risk. When an economic variable, such as an exchange rate or stock price, moves too far up or down in a short period of time, it is known as overshooting. This overshooting is known to be triggered by price rigidities or anxiety caused by financial market fluctuations. Price rigidity refers to the degree to which prices are difficult to adjust in the market.

 

 

To understand the overshooting of exchange rates due to price rigidities, let’s look at currencies as a type of financial asset and see how exchange rates adjust in the short and long term in response to economic shocks. When a shock occurs in the economy, prices or exchange rates go through an adjustment process to absorb the shock. Prices are rigid in the short run due to long-term contracts and utility regulation, but they adjust elastically in the long run. Exchange rates, on the other hand, are also elastic in the short run. This difference in the speed of price and exchange rate adjustment is what causes overshooting. The elasticity of exchange rates in the long run is explained by the purchasing power parity theory, which states that the long-run exchange rate is the ratio of the domestic price level divided by the foreign price level, which is the equilibrium exchange rate. For example, if Korea’s currency volume increases and is maintained, Korea’s prices will also increase in the long run, and the long-run exchange rate will rise. In this case, the real volume of money divided by the price level remains unchanged.
However, in the short term, the rigidity of prices may cause the exchange rate to move differently from the exchange rate based on the purchasing power parity theory, resulting in overshooting. For example, if Korea’s money supply increases and is maintained, the rigidity of prices will cause the real money supply to increase and market interest rates to fall. In a situation where capital flows freely between countries, a decline in market interest rates leads to a decline in the expected rate of return on investment, causing short-term foreign investment funds to leave the country or discouraging new foreign investment flows. In the process, the domestic currency depreciates and the exchange rate appreciates. The effect of the increase in money supply is the exchange rate appreciation that would be expected if inflation were elastic, plus the additional appreciation induced by the outflow of funds as interest rates fall. This additional appreciation is an overshoot of the exchange rate, with the degree and persistence of the overshoot being greater the greater the price rigidity. Over time, as inflation rises and the real volume of money returns to its original level, and funds that had been flowing out of Korea return to Korea as market interest rates rebound, the overshooting exchange rate in the short run converges to an exchange rate based on purchasing power parity in the long run.
To prevent and deal with short-term exchange rate misalignments with underlying economic conditions, which can lead to excessive fluctuations and prolonged departures from the equilibrium exchange rate level, governments use a variety of policy instruments. Examples of less coercive policy measures to mitigate price rigidities that contribute to overshooting include prompt and accurate disclosure of relevant information to address foreign exchange supply and demand imbalances, or reducing unnecessary price controls. To mitigate the negative spillover effects of overshooting, governments may also seek to prevent a sharp contraction in domestic demand by adjusting taxes on imported essential goods whose prices have risen sharply in response to exchange rate movements. They may also offer exchange rate risk insurance to importers and exporters to protect against the damage caused by exchange rate fluctuations, or provide payment guarantees for foreign currency borrowing. These policy instruments are highly direct in nature. In this way, governments tolerate exchange rate trends that reflect underlying economic conditions, but utilize ex ante or ex post fine-tuning policy instruments to stabilize the real economy and financial markets against the risks of short-term exchange rate fluctuations.
The selection and implementation of policy instruments should not be merely a theoretical approach, but should carefully consider their applicability and effectiveness in real-life situations. This is because the government’s policy implementation directly affects people’s lives. For example, government intervention to stabilize the exchange rate can have a significant impact on importers and exporters. Exporters can expect to make more money from a higher exchange rate, while importers may suffer from increased costs. Therefore, it is important for governments to balance the interests of different economic actors and come up with a balanced policy.
In addition, the government’s ability to implement its policies and the public’s trust in it are also important variables. The success of a policy depends not only on the nature of the policy instrument, but also on the capacity of government agencies to implement it and the cooperation of the public. To maximize the effectiveness of their policies, governments should strive for transparent and fair policy implementation. This is an important factor in building public trust and increasing the acceptability of policies.
Finally, cooperation with the international community is also a factor that cannot be ignored. In a globalized economy, economic indicators such as exchange rates are often difficult to control by a country’s economic policies alone. Therefore, cooperation and coordination with the international community is necessary, which is also important for international economic stability and growth. For example, major economic powers can work together to coordinate their exchange rate policies to minimize instability in the global economy.
Governments should consider all of these factors when selecting and implementing policy measures. This is an essential process for improving the living standards of its citizens and promoting sustainable economic growth. The role of the government goes beyond regulation and control to formulate comprehensive policies for the welfare and economic stability of the people and effectively implement them. Through this process, the government will be able to gain the trust of the people and build a better society.