Set out why central banks or governments intervene in currency markets or impose capital controls, and how well such measures work
The idea
Authorities intervene or impose capital controls to damp volatility, resist appreciation that hurts exporters, defend a peg, or slow hot money flows and asset bubbles. In large developed markets intervention rarely has lasting effect, because daily turnover dwarfs reserves. Emerging economies have better odds, since their markets are smaller relative to reserves and many hold large buffers. Selling reserves to defend a weak currency is limited by the reserve stock; buying foreign currency to resist appreciation is limited by sterilisation costs and inflation risk. Capital controls can be a legitimate temporary tool against inflow surges but distort allocation and erode as investors evade them. The trap is assuming large reserves make any peg defensible.
In the app: 2 practice questions on this outcome, a narrated walkthrough with diagrams, spaced review that brings it back before you forget it.
Take the free diagnostic →More in Currency Exchange Rates: Understanding Equilibrium Value
- For a spot or forward currency quote, work out and explain its bid–offer spread and say what makes that spread wider or narrower
- Given bid–offer quotes for three currencies, spot a triangular arbitrage and work out the profit it yields
- Explain spot and forward exchange rates and work out a currency's forward premium or discount
- Work out a forward contract's value when marked to market
- Explain the international parity conditions, namely interest rate parity in its covered and uncovered forms, the international Fisher effect, purchasing power parity and forward rate parity
- Set out how the international parity conditions link to one another
- Judge how well today's spot rate, the forward rate, uncovered interest parity and purchasing power parity each forecast future spot rates
- Explain the ways of estimating what an exchange rate is fairly worth over the long run
- Explain the carry trade and its link with uncovered interest rate parity, and work out what it earns
- Explain how the flows recorded in the balance of payments move exchange rates
- Explain what fiscal and monetary policy may do to exchange rates
- Set out the signals that a currency crisis may be coming