Question

To keep the dollar from falling against the West German mark, the European central banks would have to sell marks and buy dollars, a procedure known as intervention. But the pool of currencies in the marketplace is vastly larger than all the government’s holdings. Billions of dollars worth of currencies are traded each day. Without support from the United States and Japan, it is unlikely that market intervention from even the two most economically influential members of the European Community - Britain and West Germany - would have much impact on the markets. However, just the stated intention of the Community’s central banks to intervene could disrupt the market with its psychological effect. Economists say that intervention works only when markets turn unusually erratic, as they have done upon reports of the assassination of a President, or when intervention is used to push the markets along in a direction where they are already headed anyway. a) Can you think of reasons why a government might willingly sacrifice some of its ability to use monetary policy so that it can have more stable exchange rates?

Answer 1

When countries are part of a currency union, or are members of a similar agreement, they attempt to keep exchange rates within that zone stable. This is usually done through intervention, which involves buying and selling of currencies.

The extent of this intervention depends on how much currency is available with the government, and how much is already available in the market. In such cases, the help of more powerful countries may be required. This is because those countries will have larger reserves of foreign exchange.

Governments are willing to make such announcements, and follow up with actual actions, as they would like the exchange rates to be stable. The advantages of such stability are:

It allows for greater transparency in international trade - this may include tourists, importers and exporters. The transaction costs are also reduced, within such zones. Forecasts and simulations about the future become more accurate if exchange rates can be predicted. Trade with members and non-members is enhanced due the stability of prices. The adverse effects of uncertain inflation can be avoided.

However, in the process, the country loses freedom of monetary policy. For example, the country attempts to lower interest rates by increasing money supply. Prices rise, capital outflow occurs. This will also cause the currency to depreciate. The monetary policy has to be reversed, and is rendered ineffective.

Thus, governments are willing to give up some of this freedom to have stable exchange rates. This loss of freedom is compensated by the gains of stable policies.