Exchange Rate Intervention and Controls

A country’s capital flows can be advantageous if they increase domestic investment. It is worth noting that an increase in domestic investment leads to economic growth and subsequent currency appreciation, thereby attracting global investors. Even then, capital inflows should not be underrated because they can create asset price bubbles, overestimate a country’s currency, and set a boom-like investment environment that impacts the economy negatively. As a result, the government strives to create a favorable economic climate through various interventions.

Government Interventions and Controls

Objectives of the central bank or government intervention and capital controls include:

1. Liberalizations of financial markets. This is the removal of government interventions from financial markets. For instance, the removal of barriers to entry and compulsory reserve requirements. This can breed long-run economic growth. However, it can also cause financial crises.
2. Improved fiscal positions such as elimination of outstanding debt.
3. A reduction in inflation and inflation volatility.
4. A more flexible exchange rate regime.
5. Privatization of state-owned entities.
6. Easing of foreign exchange regulations and controls.

Effectiveness of Intervention and Capital Controls

These government interventions and controls should be useful in terms of:

1. Decreasing the aggregate volume of cash inflows.
2. Allowing monetary authorities to adopt independent fiscal policies.
3. Preventing excessive appreciation of the currency.

Evidence of active government intervention is limited in more developed market economies than less developed ones. This is because the ratio of FX reserves the central bank retains to that of foreign exchange trading in that currency is very small. For instance, industrialized countries maintain insufficient reserves to effectively impact their currency’s supply and demand.

In an emerging market currency, government intervention seems to lower the exchange rate. However, there is no statistical evidence to back this claim. Research studies have shown that policymakers in an emerging market might succeed in controlling the exchange rates. This argument is premised upon the fact that the ratio of FX reserves the central bank retains to that of foreign exchange trading in that currency is significantly large.

Question

An investor is based in a developed country with relatively high capital movement and flexible exchange rates on its borders. Moreover, this country has low public and private debt. If the government imposes expansionary fiscal policy, what would be the most likely impact on the country’s currency in the short run?

1. The domestic currency’s value will depreciate.
2. The domestic currency’s value will appreciate.
3. There will be an indeterminate effect on the value of the currency.

Solution

The correct answer is B. 

Expansionary fiscal policy causes high levels of government debt and interest rates attracting international capital flows, leading to currency appreciation.

Reading 8: Currency Exchange Rates: Understanding Equilibrium Value

LOS 8 (l) Describe objectives of the central bank or government intervention and capital controls and describe the effectiveness of the intervention and capital controls.