Question

Very often governments seek to alter the market's valuation of their currency by influencing relative interest rates, thus influencing the economic fundamentals of exchange rate determination rather than through direct intervention in the foreign exchange markets. Describe how this strategy works. Describe the case of the U.S. or China where the opposite effect, to the suggest here, have occurred.

Answer 1

The strategy of government’s intervention to alter the market's valuation of their currency by influencing relative interest rates, thus influencing the economic fundamentals of exchange rate is based on the economic rationale and principle that higher interest rates in a country increase the value of that country's currency relative to nations offering lower interest rates. This is because by increasing their interest rates government of a country is able to attract foreign investment. This increases demand for the home currency and this in turn increases the value of the home currency.

Now, very often government uses the tool of interest rate to alter market valuation of their currency rather than preferring to directly intervene in the foreign exchange markets because direct interventions can be risky in the long run. It poses the risk to undermine the credibility of a country’s central bank, especially when it fails to maintain stability.

In case of USA the opposite effect has occurred. This is because USA is a developed country and a developed economy with healthy reserves. Government interventions in USA are usually coordinated with other central banks, especially with the central bank of the country whose currency is being used. Also the intervention process in USA is highly transparent and so the New York Fed often deals directly with many large interbank dealers simultaneously to buy and sell currencies in the spot exchange rate market. The Federal Reserve takes all necessary actions to ensure that the interventions are sterilized and this prevents the intervention from changing the amount of bank reserves from levels consistent with established monetary policy goals.