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

International Trade and Globalisation – Foreign Exchange Rates

Objective

Explain the reasons why governments buy and sell foreign currencies and how they intervene in currency markets.

1. Why Governments Trade in Foreign Currencies

• Maintain a desired exchange rate – to keep the domestic currency at a level that supports export competitiveness or controls inflation.
• Stabilise the currency – to reduce excessive volatility that can deter investment and trade.
• Correct balance‑of‑payments problems – to address deficits or surpluses in the current account.
• Build foreign‑exchange reserves – to ensure the country can meet external obligations (e.g., debt repayments, import payments).
• Counter speculative attacks – to defend the currency against rapid selling that could trigger a devaluation.
• Influence domestic monetary conditions – by altering the supply of money through foreign‑exchange operations.

2. Types of Government Intervention

3. How Direct Intervention Works

When a government wants to strengthen its currency, it sells foreign reserves and buys domestic currency. Conversely, to weaken the currency, it buys foreign currency and sells domestic currency.

The basic accounting identity for a direct transaction can be expressed as:

\$\Delta R = -\Delta F\$

where ΔR is the change in foreign‑exchange reserves and ΔF is the change in the amount of foreign currency bought or sold.

4. Example: Maintaining a Fixed Exchange Rate

1. Suppose the official rate is \$£1 = \$1.50, but market pressure pushes the pound to $1.45.
2. The central bank sells $1.45 worth of foreign currency (e.g., US dollars) and buys £1 from the market.
3. This reduces the supply of pounds, pushing the market rate back toward $1.50.

5. Potential Consequences of Intervention

• Reserve depletion – continuous selling of foreign reserves can exhaust a country’s buffer.
• Inflation or deflation – unsterilised interventions change the money supply, influencing price levels.
• Market expectations – repeated interventions may lead traders to anticipate future actions, affecting currency speculation.
• International tensions – aggressive interventions can be viewed as “currency manipulation” by trading partners.

6. Summary Checklist

• Identify the government’s primary motive (exchange‑rate target, reserve accumulation, balance‑of‑payments correction, etc.).
• Determine whether the intervention is direct or indirect, and whether it is sterilised.
• Assess the likely short‑run impact on the exchange rate and the domestic money supply.
• Consider the longer‑run risks such as reserve loss or inflationary pressure.