Chapter 6

Government Influence
on Exchange Rates
Chapter 6
Direct intervention
• Direct intervention in currency exchange rates refers to

the actions taken by central banks or governments to
influence the value of their domestic currency in
relation to other currencies. These interventions are
aimed at achieving various economic objectives.
Reasons for Direct Intervention
To smooth exchange rate movements

To establish implicit exchange rate boundaries
To respond to temporary disturbances
Smoothing Exchange Rate Movements
Central banks may intervene to smooth out abrupt movements in
the value of their domestic currency. By doing so, they aim to
reduce exchange rate volatility and make business cycles less
volatile. Smoothing currency movements can also help reduce
fears in financial markets and discourage speculative activity that
could lead to a significant decline in a currency's value. This, in
turn, promotes stability and encourages international trade.
Establishing Implicit Exchange Rate
Boundaries:
Some central banks aim to maintain their domestic currency
rates within unofficial or implicit boundaries. Analysts often
forecast that a currency will not fall below or rise above a
certain benchmark value because the central bank would
intervene to prevent it. By establishing these implicit
exchange rate boundaries, central banks provide a sense of
stability and predictability in the foreign exchange market.
Responding to Temporary Disturbances
In certain situations, central banks may intervene to protect their

currency's value from temporary disturbances. For example, during
times of economic or political instability, investors may sell the
local currency and move their funds out of the country. In such
cases, the central bank may intervene to prevent the currency's
value from weakening. This intervention aims to maintain
confidence in the currency and stabilize the financial markets.
Reliance on Reserves
 Central banks hold reserves in foreign currencies, such as U.S. dollars,
which they can use in direct intervention to influence their currency's value
in the foreign exchange market.
 For example, the central bank of China, with substantial reserves, can
intervene more effectively than many other Asian countries.
 The level of reserves held by a central bank determines its ability to exert
pressure on its currency's value.
 If a central bank has low reserves, market forces may overwhelm its actions.
Coordinated Intervention
• Direct intervention is more likely to be effective when coordinated by
several central banks.
• Coordinated intervention requires agreement among central banks on the
need to adjust a particular currency's value.
• For example, if the ECB, the Bank of England, and the Fed agree that
the euro's value is too high, they can engage in coordinated intervention.
• Differences among central banks must be resolved before considering
direct intervention.
Non-sterilized versus Sterilized Intervention
• Non-sterilized intervention involves the central bank intervening in the foreign

exchange market without adjusting for the change in the money supply.
• In non-sterilized intervention, if the central bank exchanges dollars for foreign
currencies to strengthen foreign currencies (weaken the dollar), the dollar
money supply increases.
• Sterilized intervention involves the central bank intervening in the foreign
exchange market while simultaneously engaging in offsetting transactions in
the Treasury securities markets.
• In sterilized intervention, the money supply remains unchanged.
Direct Intervention as a Policy Tool
Direct intervention in currency exchange rates is a policy tool used by central
banks to influence the value of their home currency. This intervention can be
aimed at either weakening or strengthening the currency, depending on the
desired economic objectives. Here are some key points about direct
intervention:
Influence of a Weak Home Currency
Influence of a Strong Home Currency
Impact on Economic Conditions
Influence of a Weak Home Currency
Central banks may implement direct intervention to weaken
their home currency in order to stimulate foreign demand for
their country's products.
A weak currency, such as a weak dollar, can boost exports and
create jobs in the country.
However, a weak currency can also lead to higher inflation as
imports become more expensive.
Influence of a Strong Home Currency
Central banks may also implement direct intervention to strengthen their
home currency, which can help reduce inflation.
A strong currency increases the purchasing power of local consumers and
corporations, intensifies foreign competition, and keeps domestic
producers from increasing prices.
However, a strong currency may also increase unemployment as
consumers opt for foreign products over domestically produced ones.
Impact on Economic Conditions
The ideal value of a currency depends on the

perspective of the country and its officials making
decisions about direct interventions.
The strength or weakness of a currency is just one of
many factors that influence a country's economic
conditions.
Speculating on Direct Intervention in
Currency Exchange Rates
Some traders in the foreign exchange market engage in
speculating on direct intervention by central banks.
They attempt to determine when and to what extent a central
bank will intervene in order to capitalize on the anticipated
results of the intervention effort.
Speculating on Intervention Intended to
Strengthen a Currency
If speculators anticipate that a central bank will attempt to
strengthen a specific currency and believe that the intervention will
have its desired effects, they may take a position in that currency.
By purchasing the currency at a lower price before the intervention
and selling it at a higher price after the intervention, they can profit
from the expected increase in value.
Speculating on Intervention Intended to
Weaken a Currency
Alternatively, if speculators anticipate that a central bank will
attempt to weaken a specific currency and believe that the
intervention will have its desired effects, they may take short
positions in that currency.
They borrow the currency, exchange it for other currencies, and
later reverse the transaction after the intervention has occurred,
profiting from the expected decrease in value.
Central Banks' Efforts to Disguise Their
Strategy
Central banks, such as the Federal Reserve (Fed), often attempt to
intervene without being noticed.
However, dealers at major banks that trade with the central bank may
transmit the information to other market participants.
To hide their strategy, central banks may pretend to be interested in selling
a currency when they are actually buying it, or vice versa.
They may also obtain bid and ask quotes on currencies from commercial
banks without revealing whether they are considering purchases or sales.

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Chapter 6

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Government Influence

• Direct intervention in currency exchange rates refers to

To smooth exchange rate movements

In certain situations, central banks may intervene to protect their

• Non-sterilized intervention involves the central bank intervening in the foreign

The ideal value of a currency depends on the

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