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Currency analyst

How central banks control exchange rates through their monetary policy?

In this article, we decided to shed a little light on the cryptic messages coming from central banks’ officials and explain how central banks control exchange rates through their monetary policy.

As we know, a car engine makes an automobile move, pick-up the speed or slow down by regulating the amount of gasoline. The same operational principle can be applied to the work of the central bank. It provides the nation’s economy with money (economy’s fuel) to keep it healthy and growing and takes this fuel away when it’s needed. So, let’s take a peep into the central banks’ hood to understand how this banking engine works.

To handle the nation's money supply, central banks have many tools at their disposal.

For example, they can modify their interest rates. Benchmark interest rates affect the demand for money by raising or lowering the cost to borrow (well, in essence, they define how money actually cost). When borrowing is cheap (when bank sets low interest rates), firms take on more debt and increase their production; consumers purchase more goods with cheap credit; and savers are not interested in saving their money in banks; they want to invest their savings in stocks or other assets. In the world of low interest rates, currencies feel themselves uncomfortable and start to depreciate. And, on the contrary, when the high interest rates come into play, national currency grows in value.

There is another effective method of money supply regulation – open-market operations (CBs buy or sell government bonds). If central bank buys short-term government bonds, it expands money supply and thereby decreases exchange rate of its currency. If central bank acts differently (prefers to sell its bonds), it gets the opposite effect.

Central banks can also regulate money supply by mandating the reserves that banks must keep on hand. Higher reserve requirements detract people, businesses from lending and rein in inflation. But the currency remains better off. It may grossly appreciate in value, once central bank decides to take this measure.

A certain combination of the aforementioned actions is called monetary policy. There are two types of monetary policy, expansionary (that has been recently taken on board by many prominent central banks including the European Central Bank, Swiss National Bank, Bank of England, Bank of Japan) and contractionary.

Expansionary monetary policy increases the money supply in order to lower unemployment, boost private-sector borrowing and consumer spending, and stimulate economic growth. Banks lower their interest rates in order to boost economic growth of the country. 

In contrast, contractionary monetary policy slows the rate of growth in the money supply. Contractionary monetary policy is designed to fight inflation. It usually slows economic growth, increases unemployment and depresses borrowing and spending by consumers and businesses.

Armed with this information, I do hope that everybody will manage to decipher central banks’ messages.

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