The Impact of Central Banks Monetary Policy On Exchange Rate

Monetary Policy Base

Monetary policy is the country control of the money, targeting interest rate to promote economic growth and stability, stable prices and low unemployment.

Monetary theory provides insight into how to craft optimal monetary policy through expansionary and contractionary.

The expansionary policy increases the of money supply in the economy, and contractionary policy shrinks it .however, Expansionary policy used to try to combat unemployment in a recession by lowering interest rate, Contractionary policy is intended to slump down inflation and deteriorate of asset values.

Monetary baseCentral banks use open market operations to change the monetary

base by buying or selling reserve assets and financial instruments in exchange for deposit at the central bank which are convertible to currency.

Transmission MechanismTransmission mechanism:Changing monetary policy effects aggregate demand, output and prices. Focusing

on is the interest rate channel. If the central bank tightens, the economic activity will shrink accompanied by lower inflation, lower demand and lower prices.

A rise in interest rates tends to reduce business activity and borrowing, accordingly reduce spending, and Make Banks less profitable. High rates lead to an appreciation of the currency, as foreign investors seek higher return on investment and increase their demand for the currency. T exports are reduced, and imports increases, GDP shrinks.

Reserve requirementsThe monetary authority maintains control over banks. Monetary policy can be

implemented by changing the proportion of total assets in a form of cash in various supply levels in order not to expose to high volatility. Due to the lending multiplier. The ECB purchases long term government securities financed by increase the monetary base. The US and Japan pioneered QE.The ECB targets exchange rate in a form of non-sterilized foreign exchange market intervention. Switzerland became a vital member while. Sweden and Canada is about to join the club.

Enhance International Monetary StabilityAccess foreign exchange funding using alternate fund sourcing

without liquidating assets in financial markets.Develop new reserve in vehicle investment offers alternate source of

borrowing.Reduce impact of exchange rate swings it’s used to Price global

trade, denominate financial assets, peg currencies. Accordingly provide less volatile unit of currency.

Interest ratesThe shrink of the monetary supply can be achieved indirectly by

increasing nominal interest rate. In the United States, the Federal Reserve can set the discount rate, and achieve the desired fund rate by open market operations. This rate has vital effect on foreign market interest rates.High interest rates encourage savings and discourage borrowing. This influences the money supply.

Government Intervention

The central bank of each country intervenes in the foreign exchange market to control its currency purchasing power:

Smooth exchange rate movements: if the government concerned that economy will affected by currency volatility, it will smooth the currency to keep business cycles less volatile, encourage international trade to reduce uncertainty and reduce fear in the financial markets.

Establish implicit exchange rate boundaries: to maintain implicit boundaries below or above benchmark.

Respond to temporary disturbances

Direct intervention:

The government will intervene to supply or shrink the amount of dollars in the foreign exchange market to adjust the dollar value and exercise downward or upward pressures.

The effectiveness emerges from the amount of reserves it can use and coordinated with several central banks.

Direct Intervention

Unsterilized foreign exchange rates:

If the central bank purchases domestic currency by selling foreign assets, the money supply will shrink because it has removed domestic currency from the market. An unsterilized policy allows for the foreign-exchange markets to function without manipulation of the supply of the domestic currency, it exchange the domestic currency with foreign to manipulate the value.

Sterilized Foreign Exchange Rates:

Monetary action in which a central bank or federal reserve attempts to insulate itself from the foreign exchange market to effects changing monetary base. The sterilization process is used to manipulate the value; it is initiated in the foreign exchange market.

To weaken the U.S. dollar against another currency, the Fed would sell more U.S. dollars and buy the foreign currency. The increased supply of the U.S. dollar would lower the value of the currency. The Fed would do the opposite if it wanted to strengthen the U.S. dollar.

Indirect Intervention

The FED can affect the dollar value by manipulate with other economic factors such as interest rates,inflation,income levels, government controls and future expectation of exchange rates.

Intervention as a policy tool: The government may use tax law restrictions to control exchange

rates, money supply to achieve its economic objectives.

Influence a weak home currency: a weak currency stimulates exports for local products, simultaneously increase jobs reducing the unemployment rate and higher inflation rates, reducing the financing costs leads to economic growth.

Intervention as a policy tool

Floating exchange rates: If a currency value moves in any one direction at a rapid and

sustained rate, central banks intervene by buying and selling its own currency reserves in the foreign-exchange market in order to stabilize the local currency. However they are reluctant to intervene in the floating regime.

Dirty floating: The government buys back a large amount of its local currency in order to

limit currency depreciation caused by the hedge funds. True floating rate systems don't allow for intervention.

Tight monetary policy:Federal Reserve shrinks spending in an economy to curb fast growing

economy. The Fed will "make money tight" by raising short-term interest rates accordingly, increases the cost of borrowing and interest rates.