March 27th, 2017
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.