Methods to Influence the Exchange Rate
- Reserves and Borrowing. If the value of an exchange rate is falling and the government wants to maintain its original value it can use its foreign exchange reserves – e.g. selling its dollars reserves and purchase pounds. This purchase of Pound sterling should increase its value.
- Borrow The government can also borrow foreign currency from abroad to be able to buy sterling.
- Changing interest rates (In UK this is now done by the MPC) higher interest rates will cause hot money flows and increase demand for sterling. Higher interest rates make it relatively more attractive to save in the UK.
- Reduce Inflation
- Through either tight fiscal or Monetary policy Aggregate Demand and hence inflation can be reduced.
- By decreasing AD consumers will spend less and purchase less imports and so will supply less pounds. This will increase the value of the ER
- Lower inflation rate will also help because British goods will become more competitive. Thus the demand for Sterling will rise.
However this policy has an obvious side effect because lower AD will cause lower growth and higher unemployment
- Supply side measure to increase the competitiveness of the economy. This will take along time to have an effect.
UK forced out of Exchange Rate Mechanism
Note: Governments often fail in their attempt to influence the exchange rate. In 1992 the £ was in the ERM but struggled to keep its value against the DM. The Pound Sterling kept falling to its lower limit in the exchange rate mechanism.In response the government raised interest rates to 15% and bought Pound Sterling on the foreign currency reserves. However this was insufficient to stop the £ falling. Eventually the govt had to give into market pressures and exit the ERM.
The govt intervention failed because the market felt the governments intervention was not sustainable. Interest rates of 15% were disastrous for an economy already in recession.
This shows the limit of governments intervention.
Source: Economics Help
