Government Intervention

Ways Governments can influence exchange rates

Unit 14 - Lesson 2 - Exchange Rates

Governments Intervention
Governments can intervent into the currency market to
maintain the peg ratio or managed float set by the
Government. They can do this by:
1. Official Reserves
2. Limit Imports
3. Increase Interest Rates
4. Exchange Controls

Official Reserves
Official Currency Reserves:
Every central bank holds reserves of foreign currencies that they sometimes
buy or sell in order to influence the value of the domestic currency. (Tragakes)
Saudi Riyal pegged to US ($)
1. Saudi Arabia Riyal depreciates against the the US ($)
a. Supply ($) into the market -- Depreciates US ($)
b. Demand Riyal in the market -- Appreciates the Riyal
2. Saudi Arabian Riyal appreciates against the US ($)
a. Supply Riyal in the market --Depreciates the Riyal
b. Demand US ($) in the market -- Appreciates the US ($)
Central Bank uses the Currency Reserves to maintain the Pegged Rate

Limit Imports
Governments can Limit Imports through Protectionist policies such as Tariffs,
Quotas, Subsidies, or Administrative Barriers.
Saudi Riyal pegged to US ($)
Saudi Riyal depreciates against the US ($) due to an increase in imports from
the US.
Saudi Supplies Riyal to market to buy imports -- Riyal Depreciates
Saudi Demands $ from market to buy the imports -- $ Appreciates
Government intervenes and restricts the amount of imports from US
Restricted imports reduces the Supply of Riyal in the market to buy
imports thus lessening the downward pressure (depreciation) on the
Riyal.

Monetary Policy
Central Banks can influence the currency rate by manipulating the
Interest rates:
1. Open Market Operations
a. Central Bank Supply Bonds (Illiquid) -- Demand Cash from
Banks
b. Decreases Money Supply -- Increase Interest Rate
2. Reserve Ratio
a. Increase Reserve Ratio -- Decreases Supply of Money -Increases Interest Rate
b. Decrease Reserve Ratio -- Increases Supply of Money -Decreases Interest Rate

Monetary Policy
Central Bank can Appreciate or Depreciate the currency
through influencing the the Interest Rate.
1. Central Bank looks to Appreciate currency -- Decrease
the Supply of money in the market -- leads to an
Appreciation of the currency.
2. Central Bank looks to Depreciate currency -- Increase
the Supply of money in the market -- leads to a
Depreciation of the currency.

Exchange Controls
Exchange Controls is an act by which the Government restricts
the ability of the citizens from exchanging the domestic currency
(Supplying currency into market) for another currency -- aim is to
slow the Depreciation of the Domestic Currency.
Countries do this to try and prevent the flow of Capital and assets out of
the country. Reasons for this include:
1. Hyperinflation is present in the economy
2. Macroeconomic outlook for the country is not good.
Examples: Venezuela & Argentina

Pegged Currency - Fixed

Fixed Exchange Rate:
Fixed by the Central Bank
Currency not allowed to respond to changes in Supply & Demand
Maintaining a fixed Currency Rate requires constant intervention
from the Central Bank.
Intervention takes the form of buying & selling currencies by the
Central Bank
Other Government responses as previously discussed
Intervention aims to eliminate the disequilibrium in the market
caused by the Fixed Exchange Rate.

Managed Exchange Rates

Combine element of:
1. Fixed Exchange System
2. Floating Exchange System
Goal of the government is to prevent large abrupt fluctuations which
can disturb International Trade.
Government intervenes in the short-term allowing the currency to settle
towards market forces in the long-run.
Intervention in the market by the Central Bank can take the form of
any of the previously discussed ways.

Overvalued/Undervalued
Undervalued Currencies:
1. Currency that is too low relative to the market.
a. Exports become less expensive to foreign buyers.
b. Imports become more expensive.
Sometimes countries do this to boost exports & expand economies.
Sometimes referred to as the "dirty float".
Overvalued Currencies:
1. Currency is too high in relation to the market
a. Imports become less expensive.
b. Exports become more expensive.
Lead to imbalances in the Balance of Payments (discussed later)