Foreign Exchange Regimes

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.