Question

Explain why a central bank might want to intervene in the foreign exchange market to prevent excessive appreciation of its currency, even if it previously stated that it will allow its currency to respond to supply and demand conditions in the foreign exchange market.

Answer 1

Answer) In a pure floating exchange rate system, the exchange rate is adjusted as the rate that equalizes private market demand for a currency with private market supply. The central bank has no important role to play in the determination of a pure floating exchange rate. However, sometimes central banks intention or are pressured by external associations to take actions (i.e., intervene) to either raise or lower the exchange rate in a floating exchange system. When central banks do intervene on a semiregular basis, the system is sometimes referred to as a “dirty float.” There are various explanations such interventions occur.

The first reason central banks intervene is to stabilize fluctuations in the exchange rate. International trade and investment determinations are much tougher to make if the exchange rate value is changing promptly. Whether a trade deal or international investment is good or bad often depends on the value of the exchange rate that will persist at some point in the future.

If the exchange rate changes quickly, up or down, traders and investors will become more worried about the profitability of trades and investments and will likely curtail their international activities. As an outcome, international traders and investors tend to choose more stable exchange rates and will often pressure governments and central banks to interfere in the foreign exchange (Forex) market whenever the exchange rate changes too quickly.

The second reason central banks intervene is to overturn the growth in the country’s trade deficit. Trade deficits (or current account deficits) can rise quickly if a country’s exchange rate appreciates considerably. A higher currency value will make foreign goods and services somewhat cheaper, stimulating imports, while domestic goods will seem fairly more expensive to foreigners, thus reducing exports. This means a rising currency value can lead to a rising trade deficit. If that trade deficit is perceived as a problem for the economy, the central bank may be pressured to interfere to reduce the value of the currency in the Forex market and thereby offset the rising trade deficit.

There are two methods central banks can use to influence the exchange rate. The indirect method is to change the domestic money supply. The direct method is to interfere directly in the foreign exchange market by buying or selling currency.