Government Intervention in Exchange Rates

Why do governments intervene in foreign exchange markets?

Governments may want to fix or maintain an exchange rate for various economic, political, and policy reasons. Here are some of the key motivations:

Price Stability: Fixed or stable exchange rates can help maintain price stability within a country. When a currency's value is stable, it reduces the risk of inflation or deflation caused by sudden and significant currency fluctuations.

Trade Promotion: A stable exchange rate can promote international trade by providing certainty to businesses engaged in cross-border transactions. It allows importers and exporters to better predict the prices of goods and services in foreign markets.

Investment Confidence: Fixed exchange rates can boost investor confidence by reducing uncertainty in international markets. Investors may be more willing to invest in a country with a stable currency, as it lowers the risk of currency depreciation affecting their returns.

Economic Stability: Governments may fix or maintain exchange rates to achieve overall economic stability. A stable currency can contribute to lower interest rates, which can stimulate economic growth and reduce the risk of financial crises.

Fiscal and Monetary Discipline: A fixed exchange rate regime often requires governments to adopt disciplined fiscal and monetary policies. To maintain the fixed rate, they may need to control inflation, maintain reasonable budget deficits, and follow sound monetary practices.

Attracting Foreign Investment: Stable exchange rates can attract foreign direct investment (FDI) by creating a favorable environment for multinational corporations and foreign investors. This can lead to job creation and economic growth.

Political Considerations: Governments may use exchange rate stability as a tool to gain or maintain political support. A stable currency can be seen as a sign of effective economic management and may enhance the popularity of the ruling party.

Currency Pegs: Some countries, especially smaller economies or those with limited international trade, may peg their currency to a stronger and more stable currency, such as the U.S. dollar or the euro. This provides stability and a reliable reference point for their own currency.

Mitigating Speculation: Fixed exchange rate regimes can help deter speculative attacks on a country's currency, as speculators may find it more difficult to profit from betting against a currency with a fixed rate.

Economic Integration: In regions with multiple countries, such as the European Union, maintaining a common currency or fixed exchange rates can facilitate economic integration and cooperation among member states.

How can governments intervene to fix a currency?

Foreign exchange intervention using reserve assets: A central bank can use its reserve assets to intervene in the foreign exchange market by buying or selling its own currency. For example, if a central bank wants to strengthen its currency, it can use its reserve assets to buy foreign currency and sell its own currency. This will increase demand for its currency and reduce supply of foreign currency, leading to a higher exchange rate.

Monetary policy: Central banks can use monetary policy tools, such as adjusting interest rates and reserve requirements, to influence the supply and demand of their currency. Governments can work with the central bank to coordinate monetary policy and maintain a stable exchange rate. For example, if a country's relative rate of interest offered by commercial banks is higher, this may attract foreign investments as the rate of return on savings will be higher, keeping the demand for the countrys currency higher.

Capital controls: Governments can impose restrictions on the flow of capital in and out of the country to control the supply of foreign currency. Capital controls can be used to support a fixed exchange rate by limiting the amount of foreign currency that can be purchased or sold by individuals and businesses.

Fixed Exchanged Rate Systems

A fixed exchange rate is a system in which the value of a currency is fixed to another currency or a commodity, such as gold. In this system, the government or central bank of a country intervenes in the foreign exchange market to maintain the exchange rate at a certain level. The exchange rate is usually set at a fixed value, and the government or central bank uses its foreign exchange reserves to buy or sell its own currency to maintain this value. A fixed exchange rate can provide stability and predictability, which can be beneficial for trade and investment. However, it can also lead to imbalances in the economy, as the government or central bank may need to intervene frequently to maintain the exchange rate.

Devaluation of a Currency and Undervalued currencies

Figure 1: Intervention after an initial appreciation

Figure 2: Intervention after an initial appreciation

Figure 3: Intervention to Devalue from current level

Figure 1 shows the market for USD, with the USD expressed in terms of Euros in a hypothetical situation. Let's say there has been an initial appreciation due to an increase in the demand for the USD therefore, the price of $1 rises from EUR0.749 to EUR0.850. However, this will cause US exports to become more expensive and therefore reduce US exports. Therefore, the US government wishes to return the currency back to it´s initial price of $1:EUR0.749. In order to do this, the government or central bank can increase the supply of a currency (this is discussed in more detail below). As a result of the increase in supply and the intervention by governments of central banks, the currency is devalued back to the original value before the initial appriciation.

Figure 2 shows the same hypotetical market. Let´s again assume an initial increase in Demand for the USD causes the appriciation of the USD from $1 rises from EUR0.749 to EUR0.850. However, this time in order to devalue the currency, the government or central bank can decrease the demand for a countries currency, causing the USD to fall back to $1: EUR0.749.

Figure 3 shows the USD dollar at $1 for EUR0.850. In this situation, the government or central bank may wish to devalue the currency to make US exports cheaper to foreign households and therefore boost exports. Therefore, in order to do this they may intentionally increase the supply of the USD and this will cause the USD to depreciate and now $1 costs EUR0.749.

Despite the possible benefits of devaluing a currency, it also presents a number of trade off´s. Devaluing a currency intentionally may also be seen by other countries as providing an unfair advantage to exporting firms from the country (as price of exports decreases with the devaluation) and therefore other countries may impose tariffs and other measures in order to protect domestic firms from the now cheaper imports.

Undervalued Currencies

An undervalued currency is a situation where the exchange rate of a currency is considered to be lower than its fundamental value, based on factors such as economic fundamentals, trade balances, and inflation rates. This means that the currency is trading at a lower value than what is considered reasonable or justifiable based on these underlying factors. In other words, an undervalued currency is one that is artificially low in value compared to its true worth in the foreign exchange market. An undervalued currency can have both positive and negative effects on a country's economy. It can make exports more competitive, boost economic growth, and reduce trade deficits. However, it can also make imports more expensive and lead to inflation.

Consequences of an Undervalued Currency

An undervalued currency can have both positive and negative consequences on an economy, including:

Increased Competitiveness: An undervalued currency makes a country's exports cheaper, making them more competitive in international markets. This can lead to an increase in exports and help boost the overall economic growth of the country.

Trade Surpluses: An undervalued currency can also make imports more expensive, leading to decreased demand for imported goods. This can lead to a trade surplus as the country exports more than it imports.

Job Creation: An increase in exports due to an undervalued currency can lead to job creation in the exporting sectors of the economy.

Increased Economic Growth: An increase in exports, decreased imports, and trade surpluses can boost economic growth in a country.

Inflation: An undervalued currency can lead to inflation as the cost of imported goods increases. This can lead to a rise in the cost of living and reduced purchasing power for consumers.

Capital Inflows: An undervalued currency can attract foreign investment in a country as it makes the country's assets cheaper for foreign investors.

Balance of Payments: An undervalued currency can positively impact the balance of payments as the country's current account balance may improve due to an increase in exports and a decrease in imports.

However, a disadvantage to having an undervalued currency may be.

Decreased ability to import physical capital: As imports are more expensive, domestic firms may not be able to import physical capital and therefore reduce the potential growth opportunities in the long term.

Reevaluation of a Currency and Overvalued currencies

Figure 1: Intervention after an initial depreciation

Figure 2: Intervention after an initial depreciation

Figure 3: Intentional Overvaluation

When a government or central bank reevaluates its currency to a higher value in terms of another currency, it is considered to be overvalued.

In figure 1, we can see how an initial depreciation of the Euro from EUR1=$1.335 to EUR1 = $1.117, caused by a decrease in the demand for the Euro. Therefore, the European Central Bank intervenes to reevaluate the Euro back to its initial exchange rate. They can do this, in the case of figure 1, by reducing the supply of the Euro, therefore causing the exchange rate to return to the value of EUR1=$1.335

Similarly, in figure 2, we can see how the initial decrease in demand for the euro is offset by the central bank intervening and increasing demand, in order to return the exchange rate back to EUR1=$1.335.

Finally, in figure 3 we can see the process of the intervention from an original value of $1=EUR1.117, to a new overvalued rate of EUR1=$1.335.

Overvalued Currencies

An overvalued currency is a situation where the exchange rate of a currency is considered to be higher than its fundamental value, based on factors such as economic fundamentals, trade balances, and inflation rates. This means that the currency is trading at a higher value than what is considered reasonable or justifiable based on these underlying factors. In other words, an overvalued currency is one that is artificially high in value compared to its true worth in the foreign exchange market. An overvalued currency can have negative effects on a country's economy, such as reduced competitiveness in international markets and trade deficits.

Consequences of an Overvalued Currency

An overvalued currency can have several negative consequences on an economy, including:

Reduced Competitiveness: An overvalued currency makes a country's exports more expensive, making them less competitive in international markets. This can lead to a decline in exports and hurt the overall economic growth of the country.

Trade Deficits: An overvalued currency can also make imports cheaper, leading to increased demand for imported goods. This can lead to a trade deficit as the country imports more than it exports.

Unemployment: A reduction in exports due to an overvalued currency can lead to job losses in the exporting sectors of the economy.

Reduced Economic Growth: A decline in exports, increased imports, and trade deficits can reduce economic growth in a country.

Reduced Foreign Investment: An overvalued currency can reduce foreign investment in a country as it makes the country's assets more expensive for foreign investors.

Balance of Payments: An overvalued currency can negatively impact the balance of payments as the country's current account balance may suffer due to a reduction in exports and an increase in imports.

However, an advantage to having an overvalued currency may be.

Increased ability to import physical capital: As imports are cheaper, domestic firms may be able to import physical capital cheaper and therefore increase the economy's potential output and long term economic growth.

Managed Exchange Rate Systems

A managed exchange rate, on the other hand, is a system in which the exchange rate is allowed to fluctuate within a certain range, but the government or central bank intervenes in the market to prevent large or rapid fluctuations in the exchange rate. This system allows the market to determine the exchange rate, but also provides some stability and predictability to the exchange rate. A managed exchange rate can provide more flexibility and allow the market to determine the exchange rate, which can be beneficial for economic growth. However, it can also lead to volatility and uncertainty in the exchange rate, which can make it difficult for businesses to plan and invest.

Sometimes called a "Dirty Float" a currency is allowed to float between a minimum and maximum exchange rate and the government will only intervene to devalue or revalue the currency if it goes above the maximum exchange rate (devalue) or below the minimum exchange rate (revalue) the currency.

Therefore, unlike a fixed exchange rate that is kept at a certain exchange rate, a managed system floats between a certain acceptable level.

Figure 1: No intervention due to change being within the minimum and max values

Figure 2: Intervention due to change being above maximum values

In the above diagrams we can see the can see the idea of a "dirty float", where the central bank has set a minimum value (EUR1=$1.117) and maximum value (EUR1=$1.335) in which the price of the Euro expressed as $s can fluctuate or float freely. In figure 1 for example, we can see the appriciation of the euro is still lower than the maximum value of EUR1=$1.335. Therefore, the central bank or government would not intervene to manage the exchange rate.

However, in figure 2, we can see the increase in the demand for euros, causes the Euro to appriciate above the maximum value of EUR1=$1.335. Therefore, the central bank or government would intervene to manage the exchange rate.

The same would be true if the Euro was to depreciate below EUR1=$1.17. Any depreciation before this value, the government or central bank would not intervene. However, any value lower than this, the government/central bank will intervene to reevalute the currency back to the desired exchange rate.

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