Methods to Influence the Exchange Rate

1. 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.

2. Borrow The government can also borrow foreign currency from abroad to be able to
buy sterling.

3. 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. If investors wish to save in the
UK, then there will be more demand for Pound Sterling and the exchange rate will
appreciate.
 However, higher interest rates do have the effect of depressing demand in the
economy. The government may be reluctant to depress demand – just to
increase the value of the currency.

4. Reduce Inflation

 Through either tight fiscal or Monetary policy, the government can reduce Aggregate
Demand and hence inflation can be reduced.
 By decreasing, AD consumers will spend less and purchase fewer imports and so will
supply fewer pounds. This will increase the value of the ER
 The lower inflation rate will also help because British goods will become more
competitive. Thus, over time, the demand for Sterling will rise.

However, this policy has an obvious side effect because lower AD will cause lower
growth and higher unemployment

5. Supply-side measure to increase the competitiveness of the economy. This will take
a long time to have an effect. But, if successful, the UK exports will become more
competitive, increasing demand for Sterling.
6. Join fixed exchange rate. One method to influence the exchange rate is join a fixed
or semi-fixed exchange rate. The idea is that if the government are committed to a
particular target, it may encourage speculators to expect currency to stay within this
range.
 However, in practice, investors may feel government exchange rate targets are
never guaranteed and are actually an opportunity to speculate against the
government.

The UK forced out of Exchange Rate Mechanism

Note: Governments often fail in their attempt to influence the exchange rate. In 1990-
92 the Pound Sterling 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 in to 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. Therefore, high interest rates were insufficient as the markets correctly bet
interest rates would have to fall and the government devalue.

After fighting the inevitable, the government eventually was forced to leave the ERM
in October 1992. This enabled a fall in interest rates and an economic recovery.

Chinese intervention in Chinese Currency

In the past few decades, the Chinese have often followed a policy of keeping the
Chinese currency (Renminbi) undervalued.

China runs a current account surplus (due to strong export sector). With these foreign
currency reserves, they have bought foreign assets, e.g. US Treasury bonds. This
leads to increase in foreign currency reserves. But, more importantly, by buying US
assets (and supplying Chinese Renminbi, the Chinese government is effectively
reducing the value of the Renminbi.

The motivations for selling Chinese currency to buy US assets is that by keeping the
currency undervalued, Chinese exports remain very competitive. This increases
economic growth and provides jobs for the many workers leaving low-paid
agricultural work.

At various times, US commentators have criticised this policy for being a case of
‘currency manipulation‘ The argument is that by keeping the Chinese currency
undervalued, the dollar is overvalued causing a loss of US jobs.

Difference between Arbitrage

and speculation :
Arbitrage and speculation are very different strategies. Arbitrage involves the
simultaneous buying and selling of an asset in order to profit from small differences in
price. Often, arbitrageurs buy stock on one market (for example, a financial market in
the United States like the NYSE) while simultaneously selling the same stock on a
different market (such as the London Stock Exchange). In the United States, the
stock would be traded in US dollars, while in London, the stock would be traded in
pounds.

As each market for the same stock moves, market inefficiencies, pricing mismatches
and even dollar/pound exchange rates can affect the prices temporarily. Arbitrage is
not limited to identical instruments; arbitrageurs can also take advantage of
predictable relationships between similar financial instruments, such as
gold futures and the underlying price of physical gold.

Since arbitrage involves the simultaneous buying and selling of an asset, it is

essentially a type of hedge and involves limited risk, when executed properly.
Arbitrageurs typically enter large positions since they are attempting to profit from
very small differences in price.

Speculation, on the other hand, is a type financial strategy that involves a significant
amount of risk. Financial speculation can involve the trading of instruments such as
bonds, commodities, currencies and derivatives. Speculators attempt to profit from
rising and falling prices. A trader, for example, may open a long (buy) position in a
stock index futures contract with the expectation of profiting from rising prices. If the
value of the index rises, the trader may close the trade for a profit. Conversely, if the
value of the index falls, the trade might be closed for a loss.

Speculators may also attempt to profit from a falling market by shorting (selling short,
or simply "selling") the instrument. If prices drop, the position will be profitable. If
prices rise, however, the trade may be closed at a loss.