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The Role of Central Bank in Forex Market

Overview

  • Most countries have some form of Central Bank serving as the principle authority for the nation's financial matters.
  • Primary duties for a Central Bank include:
    • Implement a monetary policy that provides consistent growth and employment
    • Promote the stability of the country's financial system
    • Manage the production and distribution of the nation's currency
    • Inform the public of the overall state of the economy by publishing economic statistics

Fiscal and Monetary Policy

  • Fiscal policy refers to the economic direction a government wishes to pursue regarding taxation, spending, and borrowing.
  • Monetary policy is the set of actions a government or Central Bank takes to influence the economy in an attempt to achieve its fiscal policy.
  • Central Banks have several options they can use to affect monetary policy, but the most powerful tool is their ability to set interest rates.

How Central Banks Use Interest Rates to Implement Fiscal Policy

  • A primary role for most Central Banks is to supply operational capital to the country's commercial banks. This is done by offering loans to these banks for short time periods – usually on an overnight basis.
  • This ensures the banking system has sufficient liquidity for businesses and individual consumers to borrow money, and the availability of credit has a direct impact on business and consumer spending.
  • The Central Bank charges interest on the short-term loans it provides. The rate charged by the Central Bank affects the interest rate that the banks charge their customers as the banks must recover their cost (the interest they paid) plus earn a profit.
  • Central Banks use the relationship between the short-term rates at which it offers loans, and the interest rate the banks charge, as a way to influence the cost for the public to borrow money.
  • If the Central Bank feels that an increase in consumer spending is needed to stimulate the economy, it can lower short-term rates when providing loans to the commercial banks. This usually results in the banks lowering the interest they charge, making borrowing less costly for consumers which the Central Bank hopes will lead to an increase in overall spending.
  • If a tightening of the economy is needed to slow inflation, the Central Bank can increase interest rates making loans more expensive to acquire, which could lead to an overall reduction in spending.

Supply and Demand of Currency

  • Just like any commodity, the value of a free-floating currency is based on supply and demand.
  • To increase a currency's value, the Central Bank can buy currency and hold it in its reserves. This reduces the supply of the currency available and could lead to an increase in valuation.
  • To decrease a currency's value, the Central Bank can sell its reserves back to the market. This increases the supply of the currency and could lead to a decrease in valuation.
  • International trade flows can also influence supply and demand for a currency. When a country exports more than it imports (a positive trade balance), foreign buyers must exchange more of their currency for the currency of the exporting country. This increases the demand for the currency.
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