Government Policies and the Exchange Rate — Exchange Rates | IGCSE Economics

Exam Frequency Analysis

Past paper frequency (2018 to 2024)

This topic accounts for approximately 11% of your exam marks.

increasing

Medium

Increasing11%

Exchange rate definitions, depreciation/appreciation effects on exports, imports, and inflation are increasingly examined since 2021.

Governments and central banks can influence the exchange rate in three ways.

Direct intervention

The central bank buys or sells its own currency in the FX market.

To prevent depreciation, the central bank uses its foreign reserves to buy back its own currency. This works only as long as reserves last.
To prevent appreciation, the central bank sells its own currency (printing or borrowing as needed) and accumulates foreign reserves.

Interest-rate policy

Raising the base interest rate attracts foreign capital and pushes the currency up. Cutting rates lets the currency fall.

This is why central-bank interest-rate decisions are watched globally: they affect not just domestic borrowing but the country's exchange rate, its trade balance, and the value of foreign-currency debts in the country.

Capital controls

A few countries (China is a prominent example) limit how much capital can move in or out of the country. This insulates the exchange rate from short-term speculation but at the cost of integrating less fully with global financial markets.

Choosing a system

Fixed and floating each have trade-offs.

Fixed rates:

Pros: stable for trade and investment planning; disciplines domestic policy (cannot run high inflation without losing the peg); protects against speculative attacks (if reserves are large).
Cons: requires large foreign-currency reserves; gives up monetary-policy independence; vulnerable to attacks if reserves run low; cannot use the exchange rate as a shock absorber.

Floating rates:

Pros: automatic adjustment to economic shocks; full monetary-policy independence; no need to hold huge reserves; exchange rate absorbs trade imbalances.
Cons: more volatile, which complicates trade and investment planning; exposes the economy to speculative swings.

Most developed economies use floating rates, often with occasional central-bank intervention. Most developing economies use managed floats or some form of soft peg. Hong Kong and a handful of Gulf states are among the few with true fixed rates today.