Reasons for buying and selling foreign currencies: government intervention in currency markets

IGCSE/A‑Level Economics – Complete Syllabus Notes

Objective

Provide a concise yet comprehensive overview of all six Cambridge Economics units, with a detailed focus on why governments buy and sell foreign currencies and how they intervene in currency markets.

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1. The Basic Economic Problem

1.1 The Three Fundamental Questions

• What goods and services should be produced?
• How should they be produced?
• For whom are they produced?

1.2 Scarcity and Choice

• Scarcity: Resources are limited while wants are unlimited.
• Choice: Society must decide which goods/services to produce and who receives them.

1.3 Factors of Production

1. Land (natural resources)
2. Labour (human effort)
3. Capital (machinery, buildings, tools)
4. Enterprise (organisation, risk‑taking)

1.4 Opportunity Cost

The value of the next best alternative that is foregone when a choice is made.

Example: A farmer uses 10 ha for wheat rather than corn. The opportunity cost is the amount of corn that could have been produced on those 10 ha.

1.5 Production Possibility Curve (PPC)

• Shows the maximum output combinations of two goods when all resources are fully employed.
• Points on the curve: Efficient production.
• Points inside the curve: Under‑utilisation of resources.
• Points outside the curve: Unattainable with current resources/technology.
• Movement along the curve: Represents the opportunity cost of producing more of one good (the other must be given up).
• Shifts of the PPC:
  • Outward shift – economic growth (more resources or better technology).
  • Inward shift – loss of resources or deterioration in technology.

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2. Allocation of Resources

2.1 Demand and Supply

Change	Effect on Equilibrium Price	Effect on Equilibrium Quantity
Demand ↑ (right‑shift)	↑	↑
Demand ↓ (left‑shift)	↓	↓
Supply ↑ (right‑shift)	↓	↑
Supply ↓ (left‑shift)	↑	↓

2.2 Price Elasticity of Demand (PED)

Formula: PED = (% ΔQD) / (% ΔP)

• Elastic (|PED| > 1) – large response to price change.
• Inelastic (|PED| < 1) – small response.
• Unit‑elastic (|PED| = 1).

Determinants of PED: availability of substitutes, proportion of income spent, necessity vs luxury, time horizon.

2.3 Price Elasticity of Supply (PES)

Formula: PES = (% ΔQS) / (% ΔP)

• Elastic (|PES| > 1) – producers can increase output quickly (e.g., manufactured goods).
• Inelastic (|PES| < 1) – output cannot be changed easily (e.g., agricultural products in the short run).

Determinants of PES: time period, spare production capacity, mobility of factors, nature of the good.

2.4 Market Failure & Government Intervention

Failure Type	Cause	Typical Government Action
Public goods	Non‑rivalry & non‑excludability	Direct provision or subsidies
Externalities	Spill‑over costs/benefits	Taxes, subsidies, regulation
Monopoly power	Single seller raises price	Price caps, competition law
Information asymmetry	One side knows more	Labelling, standards
Market power (oligopoly)	Few sellers can collude	Antitrust legislation

2.5 Government Tools to Influence Markets

Tool	Purpose	Typical Effect
Price controls (ceilings/floors)	Protect consumers or producers	Potential shortages (ceilings) or surpluses (floors)
Taxes	Reduce negative externalities or raise revenue	Supply curve shifts left → higher price, lower quantity
Subsidies	Encourage positive externalities or support industries	Supply curve shifts right → lower price, higher quantity
Regulation	Set standards, safety, environmental limits	Can increase production costs → left‑shift of supply
Privatisation	Increase efficiency by transferring public firms to private ownership	Potentially lower prices, higher output (if competitive)
Nationalisation	Secure strategic sectors or correct market failure	Government control of output and pricing
Quotas	Limit quantity of imports/exports	Raises domestic price, protects domestic producers
Capital controls	Restrict flows of foreign exchange	Can stabilise exchange rate but may deter investment

2.6 Economic Systems

System	Key Features	Advantages	Disadvantages
Market economy	Resources allocated by price mechanism; limited government role	Efficient allocation, innovation, consumer choice	Potential inequality, under‑provision of public goods, externalities
Command economy	Central planner decides production & distribution	Can achieve rapid mobilisation of resources	Inefficiency, lack of incentives, shortages
Mixed economy	Combination of market forces and government intervention	Balances efficiency with equity; can correct market failures	Risk of bureaucracy, possible policy conflict

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3. Micro‑Economic Decision‑Makers

3.1 Households

• Decide how much to work, save, and spend.
• Influenced by income, interest rates, cultural values, and expectations of future prices.

3.2 Firms

• Goal: maximise profit (Profit = Total Revenue – Total Cost).
• Costs:
  • Fixed Costs (FC) – do not vary with output.
  • Variable Costs (VC) – change with output.
  • Average Cost (AC) = TC / Q.
  • Marginal Cost (MC) = ΔTC / ΔQ.
• Market structures: perfect competition, monopolistic competition, oligopoly, monopoly.

3.3 Workers

• Supply labour based on wage rates, working conditions, and alternative opportunities.
• Wage determination may involve negotiations, minimum‑wage legislation, and trade unions.

3.4 Money & Banking

• Functions of money: medium of exchange, unit of account, store of value, standard of deferred payment.
• Central bank (e.g., Bank of England, Federal Reserve):
  • Sets base interest rates (monetary policy).
  • Determines reserve requirements for commercial banks.
  • Conducts open‑market operations (buying/selling government securities).
• Commercial banks accept deposits and provide loans, creating money through the multiplier effect.

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4. Macro‑Policy

4.1 Aggregate Demand (AD) & Aggregate Supply (AS)

Component	Shift Factor (AD)	Shift Factor (AS)
Consumer confidence	Right (↑ AD)	—
Government spending	Right (↑ AD)	—
Interest rates	Left if higher (↓ AD)	—
Technology	—	Right (↑ AS)
Wage rates	—	Left if higher (↓ AS)

4.2 Fiscal Policy

• Expansionary: Increase spending or cut taxes → AD ↑ → higher output & price level.
• Contractionary: Decrease spending or raise taxes → AD ↓ → lower output & price level.
• Possible side‑effects: crowding‑out (higher interest rates), larger budget deficits.

4.3 Monetary Policy

• Expansionary: Lower interest rates, reduce reserve ratios, buy government bonds → money supply ↑ → AD ↑.
• Contractionary: Raise interest rates, increase reserve ratios, sell bonds → money supply ↓ → AD ↓.

4.4 Inflation & Unemployment

• Demand‑pull inflation: AD exceeds AS.
• Cost‑push inflation: Rising production costs shift AS left.
• Unemployment types: frictional, structural, cyclical.

4.5 Balance of Payments (BoP)

• Current account: Trade in goods & services, primary income, secondary income.
• Capital & financial account: Investment flows (FDI, portfolio, loans).
• Surplus → net foreign‑exchange inflow; deficit → net outflow.

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5. Economic Development

5.1 Indicators of Development

• GDP per capita, GNI, Human Development Index (HDI), literacy rates, life expectancy.

5.2 Obstacles to Development

• Poverty traps, inadequate infrastructure, low human capital, political instability, external debt.

5.3 Strategies for Development

Strategy	Key Actions	Intended Effect
Export‑led growth	Promote manufacturing, improve competitiveness	Earn foreign exchange, create jobs
Import substitution	Protect infant industries with tariffs & quotas	Develop domestic production
Foreign Direct Investment (FDI)	Offer tax incentives, improve legal framework	Transfer technology, create employment
Aid & Debt Relief	Negotiated concessional loans, grant programmes	Finance health, education, infrastructure

5.4 Role of International Trade

• Specialisation according to comparative advantage.
• Trade can raise national income but may expose economies to external shocks.

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6. International Trade & Globalisation – Foreign‑Exchange Rates

6.1 Why Governments Trade in Foreign Currencies

• Maintain a desired exchange rate – supports export competitiveness or controls inflation.
• Stabilise the currency – reduces volatility that could deter investment.
• Correct balance‑of‑payments problems – addresses persistent current‑account deficits or surpluses.
• Build foreign‑exchange reserves – ensures ability to meet external obligations (debt, import payments).
• Counter speculative attacks – defend the currency against rapid selling that could force devaluation.
• Influence domestic monetary conditions – foreign‑exchange operations affect the money supply.

6.2 Types of Government Intervention in the FX Market

Intervention Type	Method	Typical Objective
Direct (Spot‑market) Intervention	Central bank buys or sells foreign currency in the spot FX market.	Adjust the market exchange rate quickly.
Indirect Intervention	Alters domestic interest rates, reserve requirements, or imposes/relaxes capital controls.	Influence the currency’s value without outright market transactions.
Sterilised Intervention	After a direct transaction, the central bank conducts an opposite open‑market operation in domestic bonds.	Change the exchange rate **without** altering the domestic money supply.
Unsterilised Intervention	Direct buying/selling of foreign currency **without** offsetting bond operations.	Allow the intervention to affect both the exchange rate **and** the domestic money supply.

6.3 How Direct Intervention Works

• To strengthen the domestic currency: the central bank sells foreign reserves and buys its own currency, reducing the domestic money supply.
• To weaken the domestic currency: it buys foreign currency and sells domestic currency, increasing the domestic money supply.

Accounting identity for a direct transaction:

$$\Delta \text{Reserves} = -\Delta \text{Foreign Currency Bought}$$

where a positive ΔForeign Currency Bought means the central bank is purchasing foreign currency (weakening the domestic unit).

6.4 Example: Maintaining a Fixed Exchange Rate (Peg)

1. Official peg: £1 = $1.50.
2. Market pressure pushes the pound to $1.45 (depreciation).
3. The central bank sells $1.45 of foreign reserves and buys £1 from the market.
4. Domestic pound supply falls, pushing the market rate back toward the official $1.50.

6.5 Potential Consequences of Intervention

• Reserve depletion: Persistent selling of foreign reserves can exhaust the buffer, limiting future ability to intervene.
• Inflation or deflation: Unsterilised interventions change the money supply, influencing price levels.
• Market expectations: Repeated actions shape trader expectations; may encourage speculation or “currency wars”.
• International tensions: Perceived “currency manipulation” can provoke disputes or retaliatory trade measures.

6.6 Diagrammatic Illustration

6.7 Summary Checklist for Exam Answers

• Identify the government’s primary motive (e.g., maintain peg, correct BoP, curb speculation).
• State the type of intervention (direct, indirect, sterilised, unsterilised).
• Explain the mechanism (what is bought/sold and the effect on money supply).
• Discuss likely short‑run outcomes (exchange‑rate movement) and possible longer‑run consequences (reserve levels, inflation, expectations).
• Use appropriate terminology and, where relevant, support with a labelled diagram.