This paper examines the tools governments and central banks use to influence currency exchange rates and stabilize national economies. Using a hypothetical scenario involving U.S. and Japanese policymakers seeking to depreciate the Japanese yen relative to the U.S. dollar, the paper explains two primary mechanisms: interest rate adjustments and one-way foreign currency purchases. It further addresses common misconceptions about the effectiveness of government currency intervention and outlines how stabilization policies—both monetary and fiscal—are designed to smooth economic cycles and support full employment, drawing on the U.S. Employment Act of 1946 as a foundational reference.
The paper uses a hypothetical policy scenario as an organizing device, then unpacks the economic logic behind each policy tool. This approach — scenario-first, mechanism-second — is effective for applied economics writing because it anchors technical content in a decision-making context, making cause-and-effect relationships easier to follow.
The paper opens with a diplomatic scenario establishing the policy goal (yen depreciation), then systematically examines the two main tools available to achieve it. A final section broadens the discussion to macroeconomic stabilization policy more generally, connecting exchange rate management to the wider goals of monetary and fiscal policy. The argument moves logically from the specific to the general throughout.
A meeting between heads of state — President Obama of the United States and Prime Minister Naoto Kan of Japan — has just concluded. The focus of the discussion was the exchange rate between the U.S. dollar and the Japanese yen. The president and prime minister, along with the respective central bank heads, agreed that the current market exchange rate of 120 yen to the dollar is too high. As a result, the respective governments will take steps to drive the value of the yen lower, concomitant with an increase in the value of the dollar. To achieve this end, government and central bank directives manifest themselves in several policy options.
Many policy advisors and officials contend that currency manipulation has no significant impact on exchange rates because annual official foreign exchange purchases of $40 billion to $70 billion per year by countries such as Japan and China pale in comparison with a trillion dollars or more per day of financial transactions. The error in this assessment is to compare net and gross financial flows (Preeg, E., 2003).
The reality of government intervention in currency markets is that it can have a profound effect on exchange rates. Government action in the area of currency valuation takes on two predominant forms: interest rate adjustments and one-way purchases of foreign currencies.
In pursuit of the stated goal of depreciating the yen from 120 to 130 per U.S. dollar, the U.S. Federal Reserve could raise the target federal funds rate through open market operations by selling bonds, as well as hike the discount rate. As a result, Treasury rates would increase (see Appendix 1 — Contractionary Policies). The purpose of this interest rate increase is that "higher interest rates offer lenders in an economy a higher return relative to other countries; therefore, higher interest rates attract foreign capital and cause the exchange rate to rise" (Bergen, J., n.d.).
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