Markets - Foreign exchange market

Theory 3 - Market intervention - how can the government change things?

The Bank of England can act on behalf of the government to influence the level of the exchange rate. They have not done this since the ERM crisis of 1992, but it remains a possible option. The foreign exchange market now trades on such a significant scale (a net daily turnover in London of over $650 billion), that it is difficult for any one government to influence the markets. However, governments acting in a concerted way could certainly have an impact.

If they want to intervene, the government will need to use their foreign exchange reserves. They will need to buy or sell foreign currency as appropriate to try to influence the market. Say, for example, that the exchange rate has been depreciating for some time because of a lot of selling of the pound, and the government wants to try to slow its fall (or even reverse it). They will need to increase the level of demand for the currency, and they do this by buying sterling and selling other currencies.

We can see all this on the diagram below. The selling of sterling pushes the supply curve to the right (S1 to S2) and is forcing the exchange rate down.

The government decides to act, and so they sell various currencies (perhaps dollars, euro or yen) and buy sterling in exchange. This increases the demand for sterling, and pushes the demand curve to D2. The pound has still fallen overall, but the government's action has slowed the fall.

If the opposite was happening, and sterling was rising, then the government would need to buy foreign currency and sell sterling. This would increase the supply of sterling and help to slow down the appreciation.

For more detail on the arguments for and against fixed and floating exchange rates, you may want to look at the further work section.