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Central
Bank Intervention: The Forex Market
In a free floating exchange rate system, the
rate is determined purely by supply and demand forces of the
market. However, there are times that the central bank
intervenes to raise or lower the exchange rate in the floating
market. The central banks are often influenced by outside sources to
take part in this type of market manipulation. There are many
reasons behind this intervention by the central bank.
The main reason that the central bank practices intervention
is to stabilize fluctuations in the exchange rate. It is harder
to make international trading and investment decisions if the
exchange rate is constantly moving. If a trader feels less
confident about the stability of the exchange rate they will
reduce their investment activities.. For this reason investors
will often place pressure on the government or central bank
to intervene if the exchange rate is moving too much.
Another reason for the central banks intervention is as an
attempt to stop or reverse a country’s trade deficit. This
is because a higher exchange rate will make that countries
goods and services cheaper. This will stimulate imports while
stifling exports, creating a trade deficit. If the deficit
is significant enough the central bank may be persuaded to
intervene to try to reduce the value of the currency by dumping
excessive amounts of it on the market.
There are two
intervention approaches the central bank may
take. The direct method involves intervention by buying or
selling currency in an attempt to manipulate the market. Whereas
indirect approaches, attempt to make changes the domestic money
supply.
The direct
method is a more obvious method of intervention.
The central bank can reduce the value of a currency by flooding
the market with it. A raise in the supply of a specific currency
will lead to its depreciation n value. Conversely, the central
bank can raise the value of a currency by purchasing large
amounts of it. The increased demand of the currency will cause
it to appreciate.
The long-term effect of this direct intervention is limited.
Eventually the market will stabilize and resume its previous
trends.
The indirect
method of intervention attempts to change the
exchange rate through changes in the money supply. By increasing
the supply of money the value for that currency will decrease.
Similarly if the money supply is decreased the value for it
will increase. This approach is effective but often takes several
weeks to have an impact. This is because it must traverse all
market operations before affecting the exchange rate. Another
disadvantage of this method is that it also requires the central
bank to alter the domestic interest rate to compensate for
the change in money supply.
Intervention in the foreign exchange market is done sparingly
because of the long-term effects it may have on other domestic
factors. For example, changing the money supply will affect
interest rates and price levels. This will contribute to a
higher inflation rate, higher unemployment rates, and less
gross domestic product growth in the long run.
To avoid these long-term affects, a sterilized intervention
may be used. Sterilized intervention is intended to change
the exchange rate without changing the money supply or interest
rates. This type of intervention happens when the central bank
offsets its direct intervention by making a simultaneous change
in the domestic bond market. Studies have shown that a sterilized
intervention of the foreign exchange market will yield short-term
temporary results but ultimately have no lasting effects on
the county’s currency value. A more lasting effect can be possible
if the intervention leads to investors changing their future
expectations in the market.
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