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Why governments intervene in exchange rate

markets?

Ans.

There are multiple reasons for which governmentmay seemingly intervene in exchange rate market.

However, all such reasons can be summed into one

objective i.e. to achieve macro-economic

objective of the government.

This is because in an open economy characterizedby the presence of export and import along with

the practice of freely floating exchange rate

system, an unstable exchange rate movement of

local currency against the reserve currency as well

as other major currencies with whom trading

relationship is very strong, may create substantialmacro-economic problems. Thus government may

intervene in exchange rate market for the

following derivative reasons:

to smooth exchange rate movements and thus

avoid negative impact of exchange rate on

international trading activities.

to establish implicit exchange rate boundaries so

that domestic macroeconomic policies can yield

best result for the economy i.e. reducing

inflation, fostering growth etc.

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to respond to temporary disturbances in

exchange rates market thus restrain speculative

activities in the currency exchange market.

Explain the mechanism for government

intervention in exchange rate markets?

There are two mechanisms for government to

intervene in the exchange rate market.

1. Direct intervention:Direct intervention refers the intervention of the

government in the demand and supply side of

the foreign exchange market. Alternatively

under direct intervention the government

becomes a party to the exchange rate market

either in the demand side or in the supply sideaffecting the change rate between two

currencies. Direct intervention is most effective

when two countrys central banks coordinate

their intervention in the market; otherwise there

may be repercussion by the other government.

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a.Sterialized interventionUnder sterialized intervention the

government undertakes additional

mechanism to adjust the money supply

domestically as a result of direct action to

strengthen or weaken a currency in the

foreign exchange market.

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b.Non-sterialized intervention

Under non-sterialized intervention the

government does not undertake additionalmechanism to adjust the money supply

domestically as a result of direct action to

strengthen or weaken a currency in the

foreign exchange market.

2. Indirect intervention

Indirect intervention refers the intervention of thegovernment in the economic variables those have

the potential to affect the demand and supply side

of the foreign exchange market. Alternatively

under indirect intervention the government does

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not become a party to the exchange rate market

rather it influences the macroeconomic factors like

interest rate, inflation rate, national economy i.e.

per capita GDP etc. or impose tariff or non tariffbarriers, quota restrictions to indirectly affect the

exchange rate in the market.

If a country observe relatively higher

inflation against other country, then local

demand for foreign goods will increase i.e.

local demand for foreign currency will

increase; while foreign demand for local

goods will decrease i.e. supply of foreign

currency will decrease and vice-versa. The

combined effect will result an increase in

foreign currency value i.e. devaluation of

local currency value.

If a country observe relatively higher interestrate against other country, then local demand

for foreign investment will decrease i.e. local

demand for foreign currency will decrease;

while foreign demand for local investment

will increase i.e. supply of foreign currency

will increase and vice-versa. The combined

effect will result a decrease in foreigncurrency value.

High inflation in USA means higher Pound Value.

High interest in USA means lowerpound value.

High inflation means high interest rate??????

The answer of such dilemma has been addressed in a famous

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theory called IFE (International Fishers Effect)

If a country observes relatively higher

income level, its consumer will be able to buy

more from foreign country resulting higherdemand for foreign currency. However, the

supply of foreign currency will remain same

since the foreign countrys income level has

not changed. The combined effect will result

an increase in foreign currency value.