Exchange Rate Systems

Central banks intervene in foreign exchange markets by “influencing the monetary funds transfer rate of a nation’s currency” with the purpose of building reserves, keeping the exchange rate stable, to correct imbalances, to avoid volatility and keep credibility. It implies changing the value of a currency against another one. It creates demand or supply of a currency by buying or selling the country’s currency in the foreign exchange market. (Foreign Exchange Intervention)

Before we look at these forces, we should sketch out how exchange rate movements affect a nation 's trading relationships with other nations. A higher currency makes a country 's exports more expensive and imports cheaper in foreign markets; a lower currency makes a country 's exports cheaper and its imports more expensive in foreign markets. A higher exchange rate can be expected to lower the country 's balance of trade, while a lower exchange rate would increase it.

Currency exchange rates can be categorised as floating, in which case they constantly change based on a number of factors, or they can subsequently be fixed to another currency, where they still float, but they additionally move in conjunction with the currency to which they are pegged. Floating rates are a reflection of market movement, demonstrating the principles of both demand and supply, as well as limit imbalances in the international financial system. Fixed exchange rates are predominantly used by developing countries as they are preferred for their greater stability. They grant further control to central banks to set currency values, and are often used to evade market abuse. (MacEachern, A. 2008; Simmons, P.

Currency intervention is the action of one or more governments, central banks, or speculators that increases or reduces the value of a particular currency against another currency – this is according to Wikipedia.

The Fed has the power to reduce or rise interest rates may have an indirect effect on the dollars’ value, and September 11 effect was one of government indirect intervention that to respond to temporary disturbance. Low interest rates may reduce the amount of foreign flow of funds into the U.S., though it is still hard to predict foreign investors behavior because it is all depends on numbers of

The Federal Reserve utilizes the open market operations to affect the supply of money by purchasing and selling government securities. When the Fed purchases government securities from the public, the bank reserves will rise, and this will, in turn, increase the supply of money. Under the monetary policy, the Fed influences the supply of money by adjusting the required-reserve ratio. The reserve ratio is the amount banks are required to hold on all deposits; this limits the amount that banks can loan out. Increasing the reserve ratio would limit the amount banks can expand the money supply because the deposit and money multiplier will be smaller.When banks need to borrow from the Federal Reserve they pay an interest rate or a Discount rate. Raising the discount rate discourages banks from borrowing, in turn, lowering the money supply. The Fed will utilize the expansionary monetary policy to increase the supply of money in the market by purchasing securities, lowering

lower the value of a nation 's currency by increasing the precautionary demand for money

In 2008 the central bank licensed certain sellers to set prices in foreign currencies. It was favorable for the sellers because they bought products abroad in foreign currency. This practice was used not only by the sellers with the permission but it was widely adopted.

With the mortgage crisis recorded in the United States, the country’s currency declined in value in respect to other world currencies. Increase in money supply led to an increase in the volume of money in circulation in the United States. This led to a rise in prices of goods. Because of this, the value of the dollar declined in the international money markets. The decline in value of the dollar led to imports becoming very expensive. This further reduced the country’s production capability, leading to a further economic decline. A devalued currency makes a country’s exports cheaper than those of other countries. This has the potential of boosting the level of exports in countries with devalued currency thus reducing their balance of

(Wright and Quadrini, 2009, p. 221) In order to influence the Foreign exchange rate a country will perform an unsterilized foreign exchange intervention, subsequently, these transactions will influence the FX rate exchange because they influence the monetary base. The reasons for interventions vary, but one is to stabilize the FX exchange rate. An example of a unsterilized transaction would be if a Central Bank bought $50 million Foreign international reserves. It would increase foreign international reserves and the monetary base. In contrast, there is a sterilized transaction in which the Central Bank which should not have a long term impact on the Foreign exchange rate. To offset the purchase of the $50 million Foreign reserves it might sell $50 million domestic bonds. (Wright & Quadrini, 2009, p.

Such a process can be very time consuming and imprecise, without, of course, having a market currency price to begin with. The exchange-rate system is an important topic in international economic policy. Policymakers and journalists often seem to treat the choice of exchange-rate system as one of the most important economic policy choices that a national government makes, on a par with free international trade. Under most circumstances and for most countries, a system of freely floating exchange rates is likely to be a better choice than attempting to peg the exchange rate.

bank’s purchases of international reserves from raising the monetary base and expanding the money supply. To sterilize a capital inflow, the central bank matches its

First, the fixed nominal exchange rate has lost its real economic significance, the current RMB exchange rate formation mechanism is difficult to form market-clearing equilibrium rate. Practice, exchange settlement and capital management system in suppressing demand for foreign exchange at the same time creating a large part of foreign exchange supply, the central bank continued to intervene and the fact that the position of the largest market makers, erase all the differences between actual supply and demand. The central bank 's benchmark rate to determine the true market supply and demand balance is not the result can not reflect the market changes.

1. The gold standard and the money supply. Under the gold standard all national governments promised to follow the “rules of the game”. This meant defending a fixed exchange rate. What did this promise imply about a country’s money supply? A country’s money supply was limited to the amount of gold held by its central bank or treasury. For example, if a country had 1,000,000 ounces of gold and its fixed rate of exchange was 100 local currency units per ounce of gold, that country could have 100,000,000 local currency units outstanding. Any change in its holdings of

The traditional method adapted by Central banks to countering the effects of excess inflow (known as sterilization of capital flows) is to reduce the domestic component of the monetary base. This is done by methods like the open market operations, by selling Treasury bills and other instruments or raising the repo rate and CRR etc. But this traditional method has limited effect as instruments can be sold or interest rate can be raised only up to a certain limit. The bank faces a tricky situation here. Excess foreign capital inflow causes inflation; to check inflation Central Bank hikes interest rate; high interest rate attracts more foreign investments. Also, too much tightening of the monetary policy may hamper investment in the country. The government should therefore look into other ways of countering the negative effects of surge in capital inflow.