Exchange rate systems and government intervention

Three systems

• Floating: the rate is set by market demand for and supply of the currency, with no target. Diagram in words: price of the currency (for example $ per £) on the vertical axis, quantity of pounds on the horizontal; demand comes from foreigners buying exports and assets, supply from residents buying imports and foreign assets.
• Fixed: the central bank pegs the currency to another currency (often the US dollar) or a basket, and buys or sells currency to hold the peg.
• Managed (dirty) float: the rate mostly floats, but the central bank intervenes to limit swings or steer it within an unofficial range.

Revaluation versus appreciation; devaluation versus depreciation

• Appreciation: a rise in a floating currency's value caused by market forces.
• Revaluation: a deliberate government decision to raise a fixed currency's peg.
• Depreciation: a fall in a floating currency's value caused by market forces.
• Devaluation: a deliberate decision to lower a fixed currency's peg.

The effects are similar; the difference is the cause and the system.

How governments intervene

• Foreign currency transactions: to raise its currency, the central bank buys it using foreign currency reserves (increasing demand); to lower it, it sells its currency and buys foreign currency (adding to reserves).
• Interest rates: higher rates attract 'hot money' inflows, raising demand for the currency; lower rates do the reverse.
• Quantitative easing (QE): the central bank creates money to buy financial assets. This lowers long-term interest rates and increases the money supply, which tends to weaken the currency.

Pros and cons

Fixed: certainty for traders and investors, discipline on inflation; but needs large reserves, removes independent monetary policy, and can be attacked by speculators if it looks unsustainable.

Floating: automatic adjustment of current account imbalances, independent monetary policy, no reserves needed; but volatility creates uncertainty, and a falling currency can import inflation.

Managed: a compromise, but can be accused of manipulation.

Worked example

A central bank pegs its currency at 3.75 to the US dollar. Market pressure pushes the currency weaker. What must it do to hold the peg?

1. Weaker pressure means excess supply of the domestic currency at 3.75.
2. The central bank buys its own currency, paying with dollar reserves.
3. It may also raise interest rates to attract inflows.

Answer: Buy its own currency with foreign reserves (and/or raise interest rates).

Check yourself

1. A government raises the official value of its pegged currency. This is
   • an appreciation
   • a depreciation
   • a revaluation
   • a devaluation
   Show answer

   a revaluation. A deliberate rise in a fixed rate is a revaluation.

2. A floating currency falls in value because investors sell it. This is
   • a depreciation
   • a devaluation
   • a revaluation
   • an appreciation
   Show answer

   a depreciation. A market-driven fall in a floating currency is a depreciation.

3. To stop its floating currency falling, a central bank could
   • sell its own currency
   • cut interest rates
   • buy its own currency using foreign reserves
   • increase quantitative easing
   Show answer

   buy its own currency using foreign reserves. Buying the currency increases demand for it.

4. Explain how a rise in interest rates can cause a currency to appreciate.
   Show answer

   Higher interest rates give a better return on deposits and bonds, attracting hot money inflows from abroad; this increases demand for the currency, so it appreciates.. Capital flows respond to interest differentials.

5. Explain why quantitative easing tends to weaken a currency.
   Show answer

   QE increases the money supply and lowers interest rates, so returns on assets fall and investors move money abroad; supply of the currency rises (demand falls), so it depreciates.. Lower yields cause capital outflows.

6. Which is a disadvantage of a fixed exchange rate system?
   • Traders face more exchange rate uncertainty
   • The central bank cannot set interest rates freely for domestic needs
   • Imbalances are corrected automatically
   • No foreign currency reserves are needed
   Show answer

   The central bank cannot set interest rates freely for domestic needs. Interest rates must be used to defend the peg.

Practise with instant feedback Print this lesson

Sources

• Pearson Edexcel International Advanced Level in Economics specification (issue 2)

Last updated 8 November 2026. Spotted a mistake? Tell us.