Question

1. Why the simultaneous targeting of the money supply and interest rates is sometimes impossible to achieve?
2. How do central banks intervene in foreign exchange markets?
3. What did the Bretton Woods Agreement do to the ability of foreign exchange rates to fluctuate freely?

Answer 1

(1)

In reality, monetary policy is like driving a car (or perhaps a boat) with a very loose and wobbly steering wheel. It is very difficult to exactly predict how direct and indirect changes in the supply of base money (the money actually created by government fiat) and the government lending rates (US Federal Funds rate) will affect the supply money and short-term and longer-term interest rates.

In theory, through open market purchases and sales of US Treasury securities the Federal Reserve has a potentially direct influence on the supply of base money (but not the expanded money supply), but a much more weak influence on interest rates because of many other factors in an open market economy (foreign investors).

By setting the US Federal Funds rate, the US Federal Reserve can also affect the very short term interest rates at least in the downward direction and increases in bank borrowing from the Federal Reserve will increase the money supply as well. But this may have less effect on longer-term and intermediate term interest rates.

In theory, tightening the supply of base money and raising the Federal Funds rate will both reduce the money supply and short-term interest rates and can choke off inflation and economic stimulation. This was strongly shown in the excessively tight monetary policies in late 1981 and 1982 which led to a deep recession. We also say how loose monetary policy in the US and “quantitative easing” in Europe led to increases in the supply of money and reduced interest rates in the period from 2009 through 2015 but did not have as much of a stimulative effect as expected.

There are other ways when Interest rate changes become ineffective and Central banks, Governments need to take different measures to control money supply.

Causes for Interest rate to be ineffective are

1. Foreign currency inflow/ outflow and accordingly rise and fall in domestic currency
2. Hyper Inflation/ deflation
3. Change in Market Sentiments in case of other assets like Commodity, Real estate
4. Over production/ drought

(2) A foreign exchange intervention is a monetary policy tool used by a central bank. When the central bank takes an active, participatory role in influencing the monetary funds transfer rate of the national currency. It usually does so with its own reserves or is own authority to generate the currency. Central banks, especially those in developing countries, intervene in the foreign exchange market in order to build reserves for themselves or provide them to the country's banks. Their aim is often to stabilize the exchange rate.

Central banks have a choice of different types of interventions to make use of. These can either be direct or indirect. Direct intervention, as the name suggests, has an immediate effect on the forex market, while indirect intervention achieves the objectives of the central bank via less invasive means.

• Operational Intervention: This is usually what people mean when they refer to central bank intervention. It involves the central bank buying and selling both foreign and local currency to drive the exchange rate to a targeted level. It is the pure size of these transactions that move the market.

• Jawboning: this is an example of indirect FX intervention whereby a central bank mentions that it may intervene in the market if the local currency reaches a certain undesirable level. This method, as the name suggests, is more about talking than actual intervention. With the central bank ready to intervene, traders take it upon themselves to collectively bring the currency back to more acceptable levels.

• Concerted Intervention: This is a combination of jawboning and operational intervention and is most effective when multiple central banks voice the same concerns over exchange rates. If a number of central banks increase their jawboning efforts, it is likely that one of them actually conducts operational intervention to drive the exchange rate in the desired direction.

• Sterilized intervention: Sterilized intervention involves two actions from the central bank in order to influence the exchange rate and at the same time, leave the monetary base unchanged. This involves two steps: The sale or purchase of foreign currency, and an open market operation (selling or buying government securities) of the same size as the first transaction.