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

Why do we buy and sell foreign currencies?

Think of the foreign‑exchange market as a giant supermarket where different currencies are the products. The price of each currency (the exchange rate) is determined by how many people want it (demand) and how many people are offering it (supply).

• Demand for a foreign currency – When a country needs goods or services from another country, its businesses and consumers must buy that country’s currency to pay for imports. Example: A UK firm importing cars from Japan will buy Japanese yen (JPY) to pay the Japanese supplier.
• Supply of a foreign currency – When a country’s exporters receive payment in foreign currency, they sell that currency back to the market to get their home currency. Example: A Japanese company selling cars to the UK receives British pounds (GBP) and sells them for yen.

These two forces create the exchange rate – the price of one currency in terms of another. The market is always balancing supply and demand, just like a supermarket balancing stock and shoppers.

Government Intervention in Currency Markets

Governments sometimes step in to influence the exchange rate. They do this for a variety of reasons:

1. Protect exports – A weaker domestic currency makes a country’s goods cheaper abroad, boosting exports. Governments may sell their own currency to keep it weak.
2. Control inflation – A stronger currency makes imports cheaper, which can help keep prices down. Governments may buy their own currency to strengthen it.
3. Stabilise the economy – Sudden swings in the exchange rate can hurt businesses and consumers. Intervention can smooth out these fluctuations.

Tools used by governments:

• Direct intervention – Buying or selling currency directly in the market. Example: The UK government buys GBP to support the pound during a crisis.
• Indirect intervention – Using monetary policy tools such as changing interest rates or reserve requirements to influence the currency indirectly.
• Policy measures – Capital controls, exchange‑rate bands, or agreements with other central banks.

⚠️ Note: Intervention can have side effects, such as affecting the country’s foreign‑exchange reserves or causing tensions with trading partners.

Example: The UK and the Pound

During the 2020 pandemic, the UK government intervened to support the pound. They bought GBP in the market, which increased demand for the pound and pushed its value up against the euro (€) and the US dollar ($).

Exam Tips for IGCSE Economics 0455

• Know the key terms: exchange rate, demand for foreign currency, supply of foreign currency, direct intervention, indirect intervention, capital controls.
• Be able to explain why a country might intervene – use examples of export promotion, inflation control, and economic stability.
• Practice calculating exchange rates using the formula: $$ \text{Exchange rate} = \frac{\text{Domestic currency}}{\text{Foreign currency}} $$.
• When answering case studies, identify the cause (e.g., a drop in exports) and the effect (e.g., currency depreciation) and then explain the government’s possible response.
• Use diagrams to show supply and demand shifts in the currency market. Label the axes: Exchange rate (price of foreign currency) on the vertical and Quantity of foreign currency on the horizontal.
• Remember that currency markets are influenced by interest rates. Higher domestic interest rates attract foreign capital, increasing demand for the domestic currency.

📝 Practice Question: “Explain how the UK government’s intervention in the foreign‑exchange market during 2020 helped to support the pound. Use the concepts of demand and supply of foreign currency.”