How Does the Government Regulate Exchange Rates?

Money mix of foreign currency notes

Alex Segre / Getty Images

The government indirectly regulates exchange rates because most currency exchange rates are set on the open foreign exchange market (Forex). In some countries, like China, the exchange rate is fixed, and the government directly controls it. This Chinese currency rate control of their yuan, in turn, affects the U.S. Dollar. The yuan is loosely pegged to the U.S. dollar.

Government Influence

The U.S. government has various tools to influence the U.S. dollar exchange rate against foreign currencies. The nation's central bank—known as the Federal Reserve (Fed)—is an independent arm of the government. It indirectly changes exchange rates when it raises or lowers the fed funds rate—the rate banks charge to lend to each other.

For example, if the Fed lowers the rate, that drives down interest rates throughout the U.S. banking system. It also reduces the supply of money. Both of these results make the dollar stronger relative to other currencies. That's because U.S. dollar-denominated credit has become more expensive. At the same time, dollar-denominated assets generate a higher return. Both create more demand for the dollar while taking it out of circulation. The laws of demand and supply tell you that less supply and more demand drives up the price. When that happens to the dollar, it can purchase more foreign currency on forex markets.

Treasury Department Role

The Treasury Department is a government agency that also indirectly affects the exchange rate. It prints more money. This printing increases the supply and weakens the dollar. It can also borrow more money from other countries. That's done by selling Treasury notes. That increases the supply of money and increases the U.S. debt, and both will send the dollar's value down.

The third government tool is the use of expansionary fiscal policies. They weaken the dollar by increasing the money supply. But these policies can also improve economic growth. That often makes investors demand more dollars as a safe-haven. It's like a vote of confidence in the economy. Sometimes this demand is so high that investors overlook the low-interest rate they are getting by investing in dollars or U.S. Treasurys. The demand is even greater than the expansion in the supply of dollars.

Exchange rates, Treasury notes, and foreign exchange reserves offer three ways to measure the value of the dollar. Although the government is powerful in influencing exchange rates, it is still forex trading that actually changes them.

The chart below shows the Trade Weighted U.S. Treasury Index from 2000 through today.

Regulations on Foreign Exchange Trading

The Chicago Futures Trading Commission regulates forex brokers. It oversees all U.S. forex brokerage companies, enforces its regulations, and prosecutes outright fraud. Its authority was strengthened in 2010 with the Dodd-Frank Wall Street Reform Act.

Approximately 95% of the $5.3 trillion traded daily on forex markets are spot currency transactions, rather than futures transactions. Since they consist of two-day delivery rather than cash, they are considered the same as futures contracts. For this reason, brokers must register as a Commodity Trading Advisor, a Futures Commission Merchant, an Introducing Broker, or a Commodity Pool Operator with the Commodity Futures Trading Commission and become members of the National Futures Association. 

The U.S. National Futures Association (NFA) is a self-regulating association. All U.S. forex brokers operating for other U.S. clients must register. The NFA’s objective is to protect the integrity of U.S. markets and to protect investors from fraud. But it doesn't get involved with the value of any particular currency.

In addition, banks are responsible for most of the trades. The Federal Reserve regulates many of them. For example, in 2013, the Fed required banks to add more liquidity. They began buying Treasurys since they could be sold for cash whenever crisis threatened. The 25 largest banks increased their Treasury holdings by 88% in February 2015. It pushed down yields on long-term Treasurys. That strengthened the dollar. 

The affect of bonds on the stock market could depend on how the economy is doing. If the economy slows down, investors may prefer to invest in safer instruments, such as bonds, rather than in the more unpredictable stocks. However, this is not a formulaic response because sometimes stocks and bonds can go up or down in value at the same time.

In addition to the above, the U.S. Treasury Department is always on the lookout for any price-fixing in forex trading.