[MUSIC] Just a moment ago, we talked about how currency values affect the economy. And we mentioned a really simple, simple prediction, if you want, of how a rising or a falling currency would affect a country. You just need to be aware that this isn't always the case in every situation. As I mentioned, it's much more complex than this, and a lot depends on the elasticity of demand for imports and exports. And there's a whole body of knowledge there. But anyway, I've given you some general, general guidelines. [COUGH] What I'd like to look at now is what governments can do in a currency market. Now, we mentioned in our very first session that governments and speculators can influence the value of a currency. So here, let's set this be the Chinese yuan, for example. And [COUGH] let's imagine that this is its value. And let's imagine as well that the government likes that value, okay? So we'll put a P star on it. It becomes kind of a target value. The government likes it. Now, we'll be seeing in a few moments, not in every country does the government try to achieve a certain currency value. A lot of countries allow their currencies to float freely. But there are many countries where they try to fix a currency value. They have an objective, a target currency value. So let's imagine that that's the value of the yuan that the government likes. And let's imagine that something happens in China which causes the demand for their currency to rise, okay? So [COUGH] demand goes up, it could be because they raise interest rates. It could be because they have a trade surplus. It could be because a lot of investors want to put their money there. Whatever it might be, right? And so this causes the currency to rise in value. [COUGH] Now, maybe the Chinese government doesn't like the currency to rise in value, because as we just saw in the last segment, maybe they are concerned that that would cause China to be able to export less, therefore it would grow less, okay? And so this would sort of put their whole strategy on hold. So they decide that they want to get the currency back down there to P star, okay? How can they do this? Well, there's a number of different things we can do. I want you to just think right now about two things, which are the primary ones. One could be that they change the interest rate, okay? Just using an i. Remember we said that interest rates are an important determinant of the value of a currency. So [COUGH] if I reduce the interest rate, if I reduce my official interest rate, this is going to mean that fewer people are going to demand my currency, okay? And this could push this curve back in. So that might work. That might be something they could do. Another thing they might do is they might say, okay, you know what I'm going to do? I will go out onto foreign currency markets. I will take yuan, and I will buy foreign currency with my yuan, okay? So they will supply foreign currency to currency markets. Excuse me, they will supply their own currency to currency markets and buy, for example, dollars. Now, we'd have to have a dollar graph over here to see what that's doing. But let's just think about the supply. So we put lots of yuans on the market and we buy dollars with them. What will happen is that the currency will decline in value, and it will go back to P star, okay? At the same time, what's going to be going on over here, let's imagine the government has a little vault here where it keeps its foreign currency holdings. We call these its reserves, and we'll encounter them again in the balance of payments. So the Chinese government has gone out onto foreign currency markets, it has bought dollars in order to bring down the value of the yuan, and what's happening in here is that the reserves are going up, okay? So foreign currency reserves are building. Often you can tell whether a country is intervening to keep its currency down because reserves are going up, and that is a public figure that we can observe in different countries, okay? So this is what I might do to reduce the value of the currency, okay? What if the opposite is happening? Let's imagine instead that what has happened in China is that demand has declined, okay? So demand has gone down for whatever reason, and the value of the currency is falling. Now both of these things have happened in China in the past, so we've observed both of these interventions. Imagine the currency is going down and the government wants it to go up to P star, okay? So now we're going to think about what they could do to raise the value of their currency. And again, speaking very simply, what could they do? Well, they could increase their interest rate, which would raise demand for the currency, bring us back there, bring us back to P star. Or they could buy their currency, instead of buying foreign currency, okay? So they go onto international exchange markets, they take money out of their reserves, they take dollars, and they buy yuan with those dollars. What happens here then is this demand curve moves to the right, okay? Reserves will be going down. And so you can observe if the reserves are falling, then you figure the government may be intervening to try to bring the value of its currency up, okay? So we have these two possibilities. If I'm trying to decrease the value of the currency, I might cut interest rates. I might buy foreign currency with my currency, right? My reserves would go up. Or if I want to raise the value of the currency, I might raise the interest rate. I might go out there and buy my currency with my reserves. I would observe that the reserves are going down. Again, approaching this very simply, but these are two things that governments can do in markets to influence the value of their currency, if in fact they do have a target currency value in mind. [MUSIC]
