Question

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If a country allows international trading in its currency and wants to maintain a fixed exchange rate, it must intervene in the currency markets. Explain. What would a government do if it was trying to prevent its currency from depreciating?

Answer 1

Answer :

To prevent its currency from depreciating measures taken by the Government are :

1)Setting Official Currency Rate: Countries can set an official exchange rate that is conducted for all official business, even if it does not represent reality. This is the ultimate option for governments worried about their currencies depreciating past the point of no return

2)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.

3)Capital Control: Countries can also attempt to control their currency market by using restrictive policies that prevent people from moving money out of a country.

4)Increased Intrest Rate: Currency markets have always been dominated by carrying trades – trades where investors sell a low yielding currency and buy a high yielding currency in order to profit on the difference, called the “carry”. So in order to make its currency more attractive to investors and harder to sell by speculators, a central bank can try to ensure that its currency is high-yielding through official rates or manipulating the liquidity in forwards markets.

5)Trading Restrictions: Another method of preventing its currency from depreciation is by setting severe trading restrictions aimed at preventing large amounts of currency selling. Restrictions can include maximum transaction sizes, quotas on the size of short positions a bank is allowed to carry, strict documentation requirements for all transactions, and even reserve charges on all wrong-way trades.

6)Buying of its own currency in the market: This is the most straight-forward method of controlling a currency – simply buy as much of it as possible in order to prop it up in the market. This is done to maintain pegs, but also in free-floating currencies that are in free-fall. The central bank will go out and buy a currency in size, either using their own accounts or through agency banks, setting up a fight against speculators. They may also buy foreign currency bonds which accomplishes the same thing.

7)Reduce Inflation: If inflation is relatively lower than competitors, then the countries goods will become more attractive and demand will rise. Lower inflation tends to increase the value of the currency in the long term. To reduce inflation, the government / Central bank can pursue tighter fiscal and monetary policy and also supply-side policies.

These are some of the measures which the government should take to prevent its currency from depreciating.