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Some governments impose foreign exchange controls to influence the buying and selling of currencies. Foreign exchange controls usually affect local residents who make transactions involving foreign currencies and foreign residents who make transactions involving the local currency. These governments usually aim to protect their own weak currencies, which people often prefer to exchange for other, stronger currencies.
From 1870 to 1914, most countries fixed their currencies to gold; the central banks of these countries conducted exchanges between gold and the local currencies. The gold standard effectively also fixed the exchange rates between different currencies. In the early 1930s, many countries abandoned the gold standard because of financial instabilities and excessive inflation brought on by World War I. A system where the International Monetary Fund (IMF) supervised various fixed exchange rates and adjusted them as necessary prevailed for almost two decades after 1944. The current system involves floating exchange rates that mostly depend on the forces demand and supply.
A government can still choose to impose foreign exchange controls for several reasons: to minimize fluctuations of exchange rates, to maintain a high or low exchange value, or to establish national pride in the stable currency. Governments often impose foreign exchange controls when a currency becomes weak and is facing threats of depreciation. A government could impose foreign exchange controls in several ways. It could restrict the possession or use of foreign currencies in the country by allocating foreign currencies or imposing currency transaction tax on currency exchanges. It could also control currency exchangers or fix the value of local currency, such as to gold or another currency.
When a government establishes foreign exchange controls, it forces owners of foreign currencies to sell it to the government to obtain the local currency. The government then allocates the foreign currencies to select groups of people. This results in local residents often facing difficulties when conducting transactions with non-residents.
For example, the Mexican central bank imposed foreign exchange controls when the peso fell in the 1980s. In effect, many people could not use the peso to buy foreign currency, adversely impacting businesses and investments in Mexico. Mexican businesses could not make transactions with foreign businesses and foreign investors chose not to risk losing their money by buying the peso.
In other words, foreign exchange controls has effects that are similar to import quotas and often lead to economic inefficiency. Governments that impose them also often have to incur high administrative expenses. Other possible effects include bribery by people who want to buy foreign currencies and the establishment of currency black markets.