Government Influence On Exchange Rates

Government Influence on Exchange
6 Rates
Chapter Objectives
 Explain how the equilibrium exchange rate is determined.

 Examine factors that determine the equilibrium exchange
rate.
 Explain how governments can use direct intervention to
influence exchange rates.
 Explain how government intervention in the foreign
exchange market can affect economic conditions.
1
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Exchange Rate Equilibrium
 The exchange rate represents the price of a currency, or

the rate at which one currency can be exchanged for
another.
 Demand for a currency increases when the value of the
currency decreases, leading to a downward sloping
demand schedule.
 Supply of a currency increases when the value of the
currency increases, leading to an upward sloping
supply schedule.
 Equilibrium equates the quantity of pounds demanded
with the supply of pounds for sale.
 In liquid spot markets, exchange rates are not highly
sensitive to large currency transactions.
Demand Schedule for British Pounds
3
Supply Schedule of British Pounds for Sale
4
Equilibrium Exchange Rate Determination
5
Factors That Influence Exchange Rates
The equilibrium exchange rate will change over time as

supply and demand schedules change.
e  f (INF , INT , INC , GC , EXP )
where
e  percentage change in the spot rate
INF  change in the differential between U.S. inflation
and the foreign country's inflation
INT  change in the differential between the U.S. interest rate
and the foreign country's interest rate
INC  change in the differential between the U.S. income level
and the foreign country's income level
GC  change in government controls
EXP  change in expectations of future exchange rates
 Relative Inflation: Increase in U.S. inflation leads to increase in

U.S. demand for foreign goods, an increase in U.S. demand for
foreign currency, and an increase in the exchange rate for the
foreign currency.
 Relative Interest Rates: Increase in U.S. rates leads to increase
in demand for U.S. deposits and a decrease in demand for
foreign deposits, leading to a increase in demand for dollars
and an increased exchange rate for the dollar.
Fisher Effect:
Real interest rate  Nominal interest rate  Inflation rate
Impact of Rising U.S. Inflation on the Equilibrium
Value of the British Pound
8
Impact of Rising U.S. Interest Rates on the Equilibrium
9
 Relative Income Levels: Increase in U.S.

income leads to increased in U.S. demand for
foreign goods and increased demand for
foreign currency relative to the dollar and an
increase in the exchange rate for the foreign
currency.
 Government Controls via:
 Imposing foreign exchange barriers
 Imposing foreign trade barriers
 Intervening in foreign exchange markets
 Affecting macro variables such as inflation, interest
rates, and income levels.
Impact of Rising U.S. Income Levels on the Equilibrium
11
 Expectations: If investors expect interest rates

in one country to rise, they may invest in that
country leading to a rise in the demand for
foreign currency and an increase in the
exchange rate for foreign currency.
 Impact of signals on currency speculation.
Speculators may overreact to signals causing
currency to be temporarily overvalued or
undervalued.
Factors that Influence Exchange Rates
 Interaction of Factors: some factors place upward

pressure while other factors place downward
pressure.
 Influence of Factors across Multiple Currency
Markets: common for European currencies to move
in the same direction against the dollar.
Summary of How Factors Can Affect Exchange Rates
14
Reasons for Government Intervention
1. Smooth exchange rate movements

If a central bank is concerned that its economy will be affected
by abrupt movements in its home currency’s value, it may
attempt to smooth the currency movements over time.
2. Establish implicit exchange rate boundaries
Some central banks attempt to maintain their home currency
rates within some unofficial, or implicit, boundaries.
3. Respond to temporary disturbances
A central bank may intervene to insulate a currency’s value from
a temporary disturbance.
Direct Intervention
To force the dollar to depreciate, the Fed can intervene

directly by exchanging dollars that it holds as reserves for
other foreign currencies in the foreign exchange market.
By “flooding the market with dollars” in this manner, the

Fed puts downward pressure on the dollar.
If the Fed desires to strengthen the dollar, it can exchange

foreign currencies for dollars in the foreign exchange
market, thereby putting upward pressure on the dollar.
Effects of Direct Central Bank Intervention in
the Foreign Exchange Market
Direct Intervention
 Reliance on reserves
The potential effectiveness of a central bank’s direct intervention is the
amount of reserves it can use.
 Non-sterilized versus sterilized intervention
 When the Fed intervenes in the foreign exchange market without
adjusting for the change in the money supply, it is engaging in a non-
sterilized intervention.
 In a sterilized intervention, the Fed intervenes in the foreign
exchange market and simultaneously engages in offsetting
transactions in the Treasury securities markets.
 Speculating on direct intervention
Some traders in the foreign exchange market attempt to determine when
Federal Reserve intervention is occurring and the extent of the
intervention in order to capitalize on the anticipated results of the
intervention effort.
Forms of Central Bank Intervention in the
Foreign Exchange Market
Indirect Intervention
The Fed can affect the dollar’s value indirectly by influencing the factors that
determine it.
e  f (INF , INT , INC , GC , EXP )
where
e  percentage change in the spot rate
INF  change in the differential between U.S. inflation
and the foreign country's inflation
INT  change in the differential between the U.S. interest rate
and the foreign country's interest rate
INC  change in the differential between the U.S. income level
and the foreign country's income level
GC  change in government controls
EXP  change in expectations of future exchange rates
Indirect Intervention
Government Control of Interest Rates by increasing

or reducing interest rates
Foreign Exchange Controls such as restrictions on
the exchange of the currency
Intervention Warnings intended to warn speculators.
The announcements could discourage additional
speculation and might even encourage some
speculators to unwind (liquidate) their existing
positions in the currency.
Intervention as a Policy Tool
1. A weak home currency can stimulate foreign demand

for products.
2. A strong home currency can encourage consumers
and corporations of that country to buy goods from
other countries.
How Central Bank Intervention Can Stimulate the
Economy
How Central Bank Intervention Can Reduce Inflation

Government Influence On Exchange Rates

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Government Influence on Exchange

 Explain how the equilibrium exchange rate is determined.

 The exchange rate represents the price of a currency, or

The equilibrium exchange rate will change over time as

 Relative Inflation: Increase in U.S. inflation leads to increase in

 Relative Income Levels: Increase in U.S.

 Expectations: If investors expect interest rates

 Interaction of Factors: some factors place upward

1. Smooth exchange rate movements

To force the dollar to depreciate, the Fed can intervene

By “flooding the market with dollars” in this manner, the

If the Fed desires to strengthen the dollar, it can exchange

e  f (INF , INT , INC , GC , EXP )

Government Control of Interest Rates by increasing

1. A weak home currency can stimulate foreign demand

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