FINM8007 Chap.4 Exchange Rate Determination and Intervention
Exchange Rate Determination and Intervention
Prices set by demand and supply
The balance of payments approach treats a currency like any traded good: demand slopes down, supply slopes up, and the equilibrium rate clears the market.
This chapter traces how relative inflation, interest rates, income, government controls and expectations shift those schedules, and how to measure the resulting move as a percentage change for either currency.
When governments step in
It then covers why central banks intervene, the difference between direct intervention with reserves and indirect intervention through interest rates, sterilised versus non-sterilised operations, coordinated action and capital controls.
Where marks are won and lost
The Tutorial 4 solutions reason ceteris paribus: state the one variable that changes, trace it to demand or supply of a named currency, and give the direction of the rate.
Several questions turn on why the same policy has a larger effect on a less liquid currency, or why indirect intervention can outlast direct intervention.
On numerical parts, the percentage change must be measured for the right currency, and the Quiz 1 review shows that the price currency’s move comes from the reciprocal quote.
How it connects
The five forces in this chapter return in formal shape in Chapter 5: the inflation effect becomes purchasing power parity and the interest-rate effect becomes interest rate parity and the Fisher effect.
Chapter 6 then asks whether any of these relationships can be used to forecast rates, and the group assignment asks for a currency outlook built on inflation, unemployment and policy data.
What this chapter covers
- 01
The balance of payments approach
- 02
Demand and supply schedules
- 03
Inflation, interest and income effects
- 04
Expectations and speculation
- 05
Percentage change in a quote
- 06
Cross-rate movements
- 07
Direct and indirect intervention
- 08
Sterilised intervention and capital controls
Worked example · free
Find the new equilibrium after a demand shift and measure both currencies
- 1Old equilibrium: 1.75 − 0.002Q = 1.35 + 0.002Q gives Q = 100 and P = $1.55.
- 1New equilibrium: 1.85 − 0.002Q = 1.35 + 0.002Q gives Q = 125 and P = $1.60.
- 1The pound, the base currency, changes by (1.60 − 1.55) ÷ 1.55 = +3.23%.
- 1The dollar moves from £0.6452 to £0.6250 per dollar, a change of −3.13%.
Key terms
- Equilibrium Exchange Rate
- The rate that clears the market, where the amount of a currency people want to buy matches the amount offered.
- Real Interest Rate
- The nominal interest rate less inflation, the return that attracts capital.
- Direct Intervention
- A central bank’s purchase or sale of currencies using its reserves.
- Capital Controls
- Government limits on access to and exchange of foreign currency.
- Coordinated Intervention
- Joint action by several central banks to move a currency that one bank alone could not shift.
Exchange Rate Determination and Intervention FAQ
Why does higher US inflation make the pound rise?
British goods become cheaper relative to American ones, so Americans buy more of them and demand more pounds, while the British buy fewer American goods and supply fewer pounds. Both shifts push the dollar price of the pound up.
When is indirect intervention stronger than direct intervention?
Direct intervention is limited by reserves and can be swamped by market flows, while indirect intervention changes the fundamentals, chiefly interest rates, that drive capital. Its limit is the domestic cost of higher real rates rather than the size of the reserve stock.
What does sterilisation change?
It leaves the money supply unchanged. The central bank pairs its currency trade with an opposite trade in government securities, so the exchange market operation does not alter domestic liquidity.
Why can a currency move before a central bank actually changes rates?
Traders act on expected rate changes. If they expect higher US rates to attract capital, they buy dollars at once, so the dollar can strengthen before the decision itself. That is why markets watch central bank signals as closely as their actions.
Exam move
For each of the five forces, draw the shift on the pound and dollar diagram and write the sign of the move, then compute one percentage change for each currency from a pair of quotes. Then write one paragraph explaining why a central bank might prefer raising interest rates to spending reserves, and what that choice costs at home.
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