Monetary policy, intervention and other influences on the exchange rate

Overview

What central bank intervention in the foreign exchange market involves, how quantitative easing affects the exchange rate and effectiveness of monetary policy in influencing the exchange rate.

What you need to know

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Questions from this subtopic

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1. 1

   Explain what central bank intervention in the foreign exchange market involves.

   Model answer

   Intervention means the central bank buying or selling its own currency against foreign currency in order to influence the rate. To support the currency it sells foreign currency reserves and buys its own, adding to demand for it, and to hold the currency down it sells its own currency and buys foreign assets, adding to supply of it and accumulating reserves. Intervention can be direct in the market or signalled through announcements, and it may be sterilised, meaning the central bank offsets the effect on the domestic money supply through open market operations, or unsterilised, meaning it does not.

2. 2

   Why is a central bank's ability to support its own currency more limited than its ability to hold it down?

   Model answer

   Holding a currency down requires selling it, and a central bank can create unlimited quantities of its own currency, so in principle it can continue indefinitely, subject only to the inflationary consequences of the money it is issuing. Supporting a currency requires buying it with foreign currency reserves, and reserves are finite. Once the market believes the reserves are close to exhaustion, selling pressure intensifies, so the defence tends to fail suddenly rather than gradually. This asymmetry is the central weakness of any commitment to defend a fixed rate under pressure.

3. 3

   Analyse how a rise in the central bank's policy interest rate is transmitted to the exchange rate.

   Model answer

   The higher policy rate raises the return available on short-term deposits and on newly issued government debt in that currency. Internationally mobile funds move towards the higher return, so foreign investors buy the currency, increasing demand for it, and domestic investors are less inclined to place funds abroad, reducing supply of it. The rate appreciates. The size of the effect depends on how much of the rise was already expected and priced in, on the perceived riskiness of the currency, and on whether other central banks are moving in the same direction at the same time.

4. 4

   Analyse how quantitative easing affects the exchange rate.

   Model answer

   When a central bank creates money to buy government bonds and other assets, it raises the quantity of the currency in existence and lowers yields across the maturity spectrum, reducing the return available to holders of assets in that currency. Investors therefore shift funds towards higher-yielding currencies, increasing the supply of the domestic currency and reducing demand for it, so it depreciates. The announcement effect is often larger than the effect of the purchases themselves, because the market prices in the expected path of policy as soon as it is signalled.

5. 5

   Evaluate the effectiveness of monetary policy in influencing the exchange rate.

   Model answer

   Monetary policy is the most powerful single instrument a country has over its exchange rate, because interest rate differentials drive enormous and immediately mobile capital flows, and announcements can move a rate within seconds. Its limitations are important, however. What matters is the rate relative to others, so an increase matched by trading partners has no effect. Expected changes are already in the price, so only surprises move the rate. Confidence can dominate: raising interest rates in a country the market believes is in crisis can be read as a sign of desperation and cause the currency to fall further. And using interest rates for the exchange rate means not using them for domestic inflation and output, which is generally the more important objective.

6. 6

   Explain the policy conflict a central bank faces when it uses interest rates to influence the exchange rate.

   Model answer

   The interest rate is a single instrument that affects both the domestic economy and the currency. If the exchange rate is falling and needs support, the required rate rise depresses domestic consumption and investment, which is the wrong policy if the economy is already weak. If the currency is too strong, the required rate cut stimulates domestic demand, which is the wrong policy if inflation is already high. Because there is one instrument and two objectives, a central bank targeting inflation cannot also target the exchange rate, and most have chosen to let the rate float and to treat it as an outcome rather than a target.

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