Foreign Exchange Regimes
Currency Board or Central Banks
It is a monetary Authority that
makes decisions on the valuation of a nation’s currency specifically whether to
peg the exchange rate of a foreign currency to a local currency.
Features of a currency board
a. It
must have sufficient foreign currency reserves.
b. The
board maintains absolute and limited convertibility between its notes and coins
and currency against which they are pegged.
c. It
only earns profits from interests on foreign reserves.
d. It
has no power to effect monetary policy and does not lend to the government.
e. It
does not act as a lender of last resort to commercial banks.
Government Intervention in the Forex Market
Each country has a central bank that may intervene in foreign exchange market
to control its currency value. The central bank attempts to control the money
supply in the country.
Reasons for government intervention
a. To
stabilize fluctuations in exchange rates.
b. To
establish implicit exchange rate boundaries which allows the countries to move
currency within certain bounds.
c. To
respond to temporary disturbances of excess currency demand and supply in the
market.
d. To
improve the country’s trade deficits.
Types of Government Interventions
1. Direct
Intervention-The most common way of central banks’ intervention to affect the
exchange rate is to enter the private currency market directly by buying and
selling domestic currency. By doing this, central banks conduct two types of
transactions:
Selling the
domestic currency in exchange of foreign currency-This transaction will raise
the supply of the dollar and increase the demand for the pound causing a
reduction in the value of the dollar. The pound on the other hand appreciate in
value. The central banks power to reduce the dollar’s value by direct
intervention in the forex is virtually unlimited.
If the central
bank wishes to raise the value of the dollar, it will need to buy dollars in
exchange for pounds. The ability of the Central Bank to raise the value of the
dollar through direct intervention is limited to stock of pounds available in
the reserves.
2. Direct
intervention can be split into: sterilized intervention and non-sterilized
intervention.
Sterilized
intervention is a policy that attempts to influence the exchange rate without
changing the monetary base. The aim is to change the exchange rate without
affecting money supply with interest rates.
Non-sterilized
intervention is a policy that alters the monetary base. The central bank
intervene by increasing or decreasing the money supply. Money supply will
increase with the attempt to weaken the home currency and decrease to
strengthen the home currency. Authorities do this through purchase or sale of
foreign bonds with the domestic currency. This process is referred to as
Indirect intervention.
