Impact of Central Bank Intervention on Volatility of Foreign Exchange Rate - Essay Example

Impact of Central Bank Intervention on Volatility of Foreign Exchange Rate Table of Contents Introduction 3 Exchange Rate System 3 Types of Exchange Rate System and their Implication 4 Fixed exchange rate regime 4 Floating exchange rate regimes 5 Pegged exchange rate regime 5 Reason for Central Bank Intervention 6 Effectiveness of Central Bank Intervention 7 Impact of Intervention Policies 8 Conclusion 9 Reference List 11 Introduction During the 1960s, intervention was applied to assist in maintaining the rate of exchange within prearranged margins and was regarded as the important part of tool kit of the Central Bank (Abenoja, 2003). In the year 1978, the Central banks of Germany, Japan, the United States, and the Switzerland intervened together in order to maintain the dollar however, the Federal Reserve only sold foreign currencies of the value of more than $2 billion, an extensive sum at that time. The involvement was only temporarily successful in maintaining the dollar (Dominguez and Frankel, 1993). It was viewed as both ineffectual and costly and adopted an unambiguous policy towards the markets of foreign exchange. This observation was most likely influenced by the research during 1970 indicating that the exchange markets are well-organized, requiring no premium of risk to involve cross currency arbitrage (Genberg, 1981). The Europeans utilised both policies of interest rates as well as intervention in order to keep their rates of exchange within the bands set by the ERM (Exchange Rate Mechanism) of the European Financial System (Edison, 1993). The main aim of this essay is to show how various exchange rate systems existing around the globe is different from one other. Further, the essay entails the reasons for the interventions of Central Bank on the markets of foreign exchange. Usefulness of the Central Bank intervention will also be taken into consideration. Exchange Rate System The exchange rate system is the mode a country handles its currency in relation to overseas currencies and the overseas exchange markets. Exchange rate is described as the comparative cost of two exchanges or currencies and is also referred to the cost of one currency articulated in terms of another currency (Ishfaq, 2010). In today’s financial and international monetary system, the exchange rate systems adopted by the countries are very much dissimilar from those visualized at Bretton Woods instituting the World Bank and the International Monetary Fund. In the system of Bretton Woods rates of exchange were fixed/flat but adjustable. This system intended both to neglect the excessive volatility considered to distinguish floating rates of exchange and to avoid competitive depreciations, though permitting adequate flexibility in order to adjust towards basic disequilibrium under global supervision (Lyons, 2001). Private flows of capital were supposed to play only a restricted role in funding payments imbalances, as well as widespread utilization of controls could prevent volatility in such flows. Temporary funding of payment inequalities, primarily through the International Monetary Fund, could smooth the process of adjustment and prevent unduly sharp adjustment of existing account discrepancies, with their consequences on output, trade flows, and employment (Imf, 2000). Types of Exchange Rate System and their Implication There are three kinds of exchange rate regimes such as fixed, pegged, and floating exchange rate. This section will highlight the different types of system and their implication on exchange rate volatility. Fixed exchange rate regime In the system of fixed exchange rate, the Central Bank or government intervenes in currency market due to the reason that the rate of exchange stays next to the target of exchange rate (Sarno and Taylor, 2001). The Central Bank is not able to have an effect on the rate of exchange through the monetary policy. The Central Bank could utilise fiscal expansion in order to generate a surplus demand for the exchange causing an increase in the domestic output. Then the Central Bank will acquire foreign asset in order to augment the supply of money and avert the rate of interest from rising thereby causing an appreciation. Due to these constraints, the government with a flat rate of exchange will want to manage the currency’s amount which they allow in and out. This will avoid any unnecessary destabilization of home or domestic currency (Madura, 2014). All deviations on the fixed rates lessen the problem of time inconsistency and also reduce the volatility of exchange rates, albeit to dissimilar degrees (Dellas and Tavlas, 2005). Floating exchange rate regimes It is that type of regime in which a value of currency is authorized to freely vary according to the market of foreign exchange (Johnston, 1999). The currency of the country is situated by the markets of foreign exchange through demand and supply of that precise currency comparative to other currencies. In this type of system the worth of currency or money is influenced by each day markets for demand and supply. Therefore capital flows and trade play a great role in deciding the value of currency (Carbaugh, 2012). There are various types of fluctuating/floating exchange rate regimes. Clean float and dirty float and this rely on whether there is government interference or not (Meltzer, 1976). The rate of exchange could be established by both fiscal and monetary policy. The variations in the real rate of exchange is caused by the occurrence of shocks taking place in financial market which move or shift the nominal rate of exchange, which then are conceded on to the actual/real rate of exchange because of the sticky prices (Bergin, Glick and Wu, 2012). Pegged exchange rate regime When the currencies are fixed or pegged, their prices fall and rise in synchronization with each other (Aizenman and Glick, 2005). The countries which are having unstable economies, their government often have unbalanced values of currency, which means that the national currency’s value is susceptible towards constant fluctuation. Continuous changes in price means constant variations in exchange rates of currency, which deters international and trade investors because of the currency exchange instability or volatility (Cherunilam, 2010). Countries might also fix their currency towards the currency/exchange of their major trading partner states to simplify the process of trade among the countries (Cherunilam, 2010). Reason for Central Bank Intervention A Central Bank would sell or buy a currency/exchange in foreign exchange market to decrease or increase the value possessed by its nation’s currency against the alternative currency. This is referred to intervention of Central Bank or Forex intervention (Kim, 2003). When a currency of a country is enduring unnecessary and extreme downward or upward financial pressure (normally caused through high fluctuation from a flow of trading by market players and speculators) the Central Bank or government will use intervention of Forex market to soothe the situation (Canales-Kriljenko, Guimaraes and Karacadag, 2003). Central Bank interference or intervention is used to decrease or boost the value of currencies, most frequently for decreasing and boosting exports and productivity of a nation. There has been to a great extent criticism concentrated at governments who make use of market intervention exceptionally to increase their value of currency (Hung, 1997). The universal reason for intervention of Central Bank over the decades would be due to the sudden or sharp decrease in the currency’s value. It can turn difficult for a country to use the market intervention/interference whenever the value of currency does decrease sharply in overseas exchange market (Hung, 1997). Other reason for the intervention of Central Bank in the overseas or foreign exchange market is that they always favour to alleviate the rate of exchange because too much of short term instability or volatility erodes the market confidence and thus have an effect on both the market of real good and the financial market. Whenever there occurs an inordinate volatility, uncertainty of exchange rate produces extra cost as well as reduces profits (Hung, 1997). The increased instability of the financial markets could intimidate the financial system’s stability and make the goals of monetary policy more complicated to attain (Hung, 1997). When there occurs any change in the economic situations or when the economic signals are misinterpret by the markets, Central Bank use intervention of foreign exchange in order to correct the exchange rates. Though, few governments admit that profitability or productivity is a drive for intervention. The Central Bank confesses that intervention is a valuable measure of their achievement in compelling the public in favour of currency intervention (Mussa, 1981). Effectiveness of Central Bank Intervention The governments or Central Bank has intervened in the markets of foreign exchange in an attempt to reduce volatility as well as to reverse or slow currency movements. The concern of Central Bank is that too much of short term instability and the long term sways in the rates of exchange that overshoot prices justified by basic conditions might harm their economies, mostly sectors greatly involved in global trade (Saacke, 2002). It appears that interventions convey the strongest signs and comprise the highest possibility of achievement when the circumstances of publicity, surprise, as well as harmonization with Central Banks are convened. The market of foreign exchange undoubtedly has been unstable recently. The exchange rate which is market determined is believed to replicate the underlying demand and supply conditions in the flexible systems with capital mobility. The rates of exchange can depart considerably from the degree implied by the fundamentals in the short term. This fact creates a responsibility for intervention of Central Bank in the overseas exchange market in order to keep the rate of exchange in line with the entire policy mix and the economic environment, which stabilises the market expectations as well as calm uncontrollable markets (Dominguez, 1993). Official intervention by the Central Bank smoothes the market and also encourages stabilizing the private speculators. Intervention is not consistent with fundamental economies policies. Evidence advocates that intervention might stabilize rates of exchange by decreasing the everyday volatility, and also cause the exchange rates to shift in intended direction (Dominguez, 1993). Impact of Intervention Policies Most of the Central Banks which functions in floating regimes/systems intervene in the market of foreign exchange. The interventions as well did not include any unfavourable affect on long or short term volatility (Seerattan, 2006). Credible indications of the future policy eradicate uncertainty. The intervention of Central Bank typically takes place in the market of spot foreign exchange. The Central Bank trades or sells home currency, if it is powerful than required. The Central Bank’s interference or intervention may create direct results related with the transformed/changed quantities of bonds or money. The degree of effects relies on whether intervention was unsterilized or sterilized. Significance of policy’s impact: As per the monetary/financial approach, the sterilized interventions encompass no straight impact on exchange rate (Levich, 2001). Monetary policy works efficiently with the floating exchange rate system to improve or develop the position of current account at the similar time of mounting income; however it has unfavourable and little impact on the current account in the fixed exchange rate system (Wang, 2009). The intervention or involvement does not alter the near term expectations of the exchange rate as they are stated chiefly by fundamentals. A dollar purchase could increase the appreciation pressure as a big stock of executive or official reserve reduces exterior credit spreads as well as attracts more overseas inflows (Miyajima and Montoro, n.d.). Intended versus unwanted effects: Intended effects refer to the direct effects on the money supply whereas unwanted effects are described as the side effects on the bond and money supplies. The intended effect is that the supplies of money in both nations are affected. Whereas, the unwanted effects are that the supplies of money remain unchanged, however the supplies of bond are affected (Levich, 2001). Political waste of resources: The failure of government might range from trivial, when the intervention is purely ineffective, however where harm is limited to the rate of resources wasted and used up by interventions, to the case where interference or intervention produces novel as well as more serious troubles that did not subsist before. For more than the last sixty years, governments have interfered towards improving the economic and social life of the nations on an extent inconceivable to earlier generations. Yet economic and social problems continue (Riley, 2012). Conclusion The main purpose of this essay is to show the different features of different exchange rate regimes existing around the world and to explain their implications on the volatility of exchange rates. It also discusses the reasons behind the intervention of Central Banks on the markets of foreign exchange. This essay emphasized that the intervention of Central Bank to direct movements of the spot exchange prices does not appear to have a main influence on the near term expectations of the exchange rate. The interventions of government or Central Bank may have unintended consequence on the expectations of exchange rate. Reference List Abenoja, Z., 2003. Foreign exchange monetary intervention: a short review of transmission channels and practices. Bangko Sentral Review, 5(2), pp.1-2. Aizenman, J. and Glick, R., 2005. Pegged Exchange Rate Regimes – A Trap. NBER Working Paper, pp.1-4. Bergin, P., Glick, R. and Wu, J.L., 2012. Fixed versus flexible exchange rate regimes: Do they matter for real exchange-rate persistence? [online] Available at: [Accessed 10 Jan 2015]. Canales-Kriljenko, J., Guimaraes, R. and Karacadag, C., 2003. Official intervention in the Foreign Exchange Market: Elements of best practice. IMF Working Paper, 152. Carbaugh, R., 2012. International Economics. United States of America: Cengage Learning. Cherunilam, F., 2010. International Business. New Delhi: PHI Learninh Pvt. Ltd. Dellas, H. and Tavlas, G., 2005. The global implication of regional exchange rate regimes. Journal of International Money and Finance, 24(2), pp.243-250. Dominguez, K.M., 1993. Does Central Bank intervention increase the volatility of foreign exchange rates? Cambridge: National Bureau of Economic Research. Dominguez, K.M. and Frankel, J.A., 1993. Does Foreign exchange intervention work? Washington DC: Institute for International Economics. Edison, H.J., 1993. The Effectiveness of Central Bank Intervention: A Survey of the Literature after 1982. New Jersey: Princeton University. Hung, J., 1997. Intervention strategies and exchange rate volatility: A noise trading perspective. Journal of International Money and Finance, 6(1), pp.779-783. Genberg, H., 1981. Effect of Central Bank Intervention in the Foreign Exchange Market. International Monetary Fund, 28(3), p.451. Imf., 2000. Exchange Rate Regimes in an Increasingly Integrated World Economy. [online] Available at: < https://www.imf.org/external/np/exr/ib/2000/062600.htm> [Accessed 10 Jan 2015]. Ishfaq, M., 2010. Overview of Different Exchange Rates Regimes and Preferred Choice for UAE. [pdf] Available at: < http://www.dof.gov.ae/en-us/publications/Lists/ContentListing/Attachments/55/Overview%20of%20Different%20Exchange%20Rate%20Regimes%20and%20Preferred%20Choice%20for%20UAE1.pdf> [Accessed 10 Jan 2015]. Johnston, R.B., 1999. Exchange rate arrangements and currency convertibility: Developments and issues. Washington, D.C: International Monetary Fund. Kim, S., 2003. Monetary policy, foreign exchange intervention, and the exchange rate in a unifying framework. Journal of International Economics, 60(2), p.356. Levich, R.M., 2001. International Financial Markets prices and Policies. [pdf] Available at: [Accessed 13 Jan 2015]. Lyons, R., 2001. The Microstructure approach to exchange rates. Massachusetts: MIT Press. Madura, J., 2014. International Financial Management. United States of America: Cengage Learning. Meltzer, A.H., 1976. Clean and Dirty Floating. [pdf] Available at: http://repository.cmu.edu/cgi/viewcontent.cgi?article=1640&context=tepper. > [Accessed 19 Jan 2015]. Miyajima, K. and Montoro, C., n.d. Impact of foreign exchange interventions on exchange rate expectations. [pdf] Available at: < http://www.bis.org/publ/bppdf/bispap73d_rh.pdf> [Accessed 13 Jan 2015]. Mussa, M., 1981. The role of official intervention. New York: Group of Thirty. Riley, G., 2012. Government Failure. IMF Working Paper, 164. Saacke, P., 2002. Technical analysis and the effectiveness of Central Bank intervention. Journal of International Money and Finance, 21(4), pp.459-463. Sarno, L. and Taylor, M., 2001. The Economies of Exchange Rates. Cambridge: Cambridge University Press. Seerattan, D., 2006. The effectiveness of Central Bank intervention in the forign exchange markets in select flexible exchange rate countries in the Caribbean. [online] Availale at: [Accessed 12 Jan 2015]. Wang, P., 2009. The Economics of Foreign Exchange and Global Finance. Heidelberg: Springer Science & Business Media. Read More