Why a government might have an exchange rate policy

Overview

Exchange rate policy, government want a stronger currency and government want a weaker currency.

What you need to know

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Questions from this subtopic

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1. 1

   What is meant by an exchange rate policy?

   Model answer

   An exchange rate policy is a deliberate objective for the level or the stability of the currency, pursued through the instruments the authorities control rather than left entirely to whatever value emerges. It can range from a formal commitment to hold the rate near a stated value, through an unpublished preference for a stronger or weaker currency, to a policy of simply smoothing sharp swings. Having such a policy means the exchange rate becomes an objective in its own right, which necessarily constrains the use of other instruments.

2. 2

   Why might a government want a stronger currency?

   Model answer

   The most common reason is to reduce inflation, because a stronger currency lowers the domestic price of imported food, fuel, raw materials and finished goods, which pulls down the consumer price index directly and lowers firms’ costs. It also raises the real purchasing power of domestic incomes over foreign goods, so measured living standards rise, and it reduces the domestic cost of servicing any borrowing denominated in foreign currency. A government facing a serious inflation problem may therefore welcome a currency appreciation even though it damages exporters.

3. 3

   Why might a government want a weaker currency?

   Model answer

   A weaker currency makes domestically produced goods cheaper in foreign markets and imported goods dearer at home, so export volumes rise and domestic producers win business back from importers. Higher net exports raise aggregate demand, and because the demand for labour is derived from the demand for output, output and employment rise, particularly in manufacturing and other tradable sectors. A government facing high unemployment and a struggling export sector may therefore prefer a lower rate, accepting the higher import prices that come with it.

4. 4

   Why might a government value stability of the exchange rate for its own sake?

   Model answer

   Firms that trade internationally have to quote prices, sign contracts and plan investment months or years ahead, and a rate that moves sharply turns every such decision into a gamble on the currency. Uncertainty raises the cost of doing business, since firms must either buy protection against currency movements or build a margin for risk into their prices, and it deters investment in export capacity and inward investment from abroad. A stable rate therefore encourages trade and long-term investment even if the level at which it is stabilised is not ideal.

5. 5

   How can a central bank influence the exchange rate through interest rates?

   Model answer

   Financial investors move funds to wherever they can earn the best return for a given risk, so raising domestic interest rates above those available abroad attracts inflows of short-term capital, which increases the demand for the currency and pushes it up. Lowering rates has the opposite effect, encouraging funds to leave and weakening the currency. The instrument is powerful because financial flows are far larger and faster-moving than trade flows, but it is also the same instrument the central bank needs for domestic inflation, which is the source of the conflict.

6. 6

   How can the authorities influence the exchange rate directly?

   Model answer

   The central bank can enter the market itself, using its foreign currency reserves to buy its own currency when it wishes to support the rate, or selling its own currency in exchange for foreign currency when it wishes to hold the rate down. Buying support is limited by the size of the reserves, since they can be exhausted, while holding a rate down is limited by the inflationary consequences of the extra domestic currency created. Official statements about the desired level can also move the rate, because expectations matter to those holding the currency.

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