Custom essays on Foreign exchange rate

There are two basic ways for central banks to influence the foreign exchange markets: direct and indirect. Direct intervention takes place when the central bank makes a decision to sell its currency reserves in favor of a different currency (Madura, 2008). The currency which is being sold is then dumped at the exchange market, and the currency which appears in the reserves is strengthened. However, the policy of direct intervention does not work in a linear and predictable way, since there are other market forces also impacting the exchange rate. In 2000, direct intervention of the Fed and of the European Central Bank aimed at strengthening euro did not work, because of the state of the economy (Madura, 2008). However, direct intervention might change the dynamics of foreign exchange market, and also impact the foreign exchange strategies of private banks. Thus, direct intervention still makes sense as an economical leverage.

Central banks can also perform indirect intervention; in other words, they might influence the factors driving the foreign exchange markets. The major factor determining market dynamics, is money supply (Madura, 2008). By increasing money supply and thus lowering interest rates, the Fed can weaken the dollar and discourage foreign investors to invest into US market. The strategy of lowering interest rates in order to slow down the inflation and manage internal debts has been chosen by the Fed during the recession time.

Indirect way to raise interest rates is to increase the US money supply. This is aimed at reviving the economy, but can also result in faster inflation growth. Thus, this strategy of boosting the economy should be introduced only when inflation expectations are moderate, and the economy has a clear potential for growth.

It has been proved that the exchange rates cannot be viewed as correct indicators of the state of the economy, and thus intervention into foreign exchange market might not always be predictable and effective. The central banks frequently used foreign exchange intervention in 1995, but since that time, only several interventions took place (Mussa, 2000). The banks generally use “sterilized” intervention (Mussa, 2000) which means that the levels of monetary reserves are aligned with monetary policy goals.

In general, both direct and indirect interventions impact the behaviour of the investors at first, and then the supply and demand balance. Because of time lag between the intervention and its effects and due to many factors which might influence the exchange rates beside the monetary policy decisions, the practice of foreign exchange intervention takes place only in heavy situations, when it’s necessary to adjust the economy quickly and reverse its dynamics. Thus, the U.S. foreign banking system strongly depends on the exchange rates and at the same time can use various instruments of intervention to affect these rates. Foreign exchange rates also act as a major factor in regulating global trade and capital balance, and change the dynamics of supply and demand on the global market.