Rates of exchanges determine the strength of a country’s currency against other currencies, which trickles down to the prices of goods and services. A high exchange rate of your country’s currency lowers the price of imports, whereas a low exchange rate makes imports more expensive.
High exchange rates make it favorable to import goods, whereas low exchange rates are favorable for exports. For example, if you export goods, your client pays you with their currency. If your currency is low in value against the other currency, it means you get more value when you exchange it into your currency.
Effects of Monetary Policy
Monetary policy is a three-pronged strategy used by governments that uses money supply and credit availability to control exchange rates. Central banks the world over have similar goals for their unique economies. Monetary policy vests to the Central bank the power to control the interest rates, rising inflation, money supply, bank’s reserves, and lending to commercial banks.
The strategy takes any of the following ways: expansionary monetary policy, contractionary monetary policy, and non-standard monetary policies.
Expansionary Monetary Policies are steps taken by central banks to increase the money supply by lowering interest rates, purchasing security bonds, lowering bank reserve requirements. The aim is to increase overall consumer spending and enhanced economic growth. For example, cutting down the interest rates opens up credit.
Central banks increased the money supply through more accessible credit and the low tax imposed by the government. The money in your pocket consequently increases. Subsequently, you spend more on imports by selling dollars to buy foreign currencies and buy the goods, thus resulting in a decrease in the dollar exchange rate.
Contractionary Monetary Policy aims at countering the expansionary monetary policies by reducing the flow of money circulating in the economy. Specific actions by Central Banks include raising interest rates, increasing bank’s reserve requirements, and selling security bonds.
Non-Standard Monetary Policies: Non-standard policies arose out of the governments’ response to financial turmoil. It was meant to prevent further damage. Central banks can buy other none government securities in the open market to lower interest rates and increase the money supply. As a result, banks access capital to lend. This measure is referred to as quantitative easing (QE).
Central banks also employed the strategy of Forward Guidance, which involves getting individuals and businesses to spend and invest long term this bringing stability and confidence into the market.
Objectives of Monetary Policy
The primary objectives of monetary policy are inflation, unemployment, and currency exchange rates. Low inflation is healthy, whereas high inflation requires corrective measures achieved through contractionary policies. Expansionary monetary policies decrease employment while central banks control exchange rates through money supply.
Exchange Rates and Monetary Policy
Rising interest rates increase demand for currency, which in effect causes its exchange rate to rise against other currencies. A reduction in interest rates, has the opposite effect. The interest rates set by central banks are the biggest drivers of foreign exchange fates.
Effects on the Forex Markets
As central banks cut interest rates, it boosts money in circulation, thus making the local currency cheap from the foreigner’s perspective; hence its value falls, and foreign investors sell off the currency.
Alternatively, when Central Bank raises interest rates, it reduces the money on circulation because the loans become more expensive hence no borrowing. As it happens, the currency gains, and investors buy more because they consider hiked rates a good sign for economic growth.
Forex enthusiasts should watch carefully the actions of central banks and closely monitor the impact of monetary policy as well as exchange rates fluctuations. Monetary policy is a reserve of a countries central bank which controls the money in circulation. The controlled supply of money regulates inflation.
To effectively manage these, the government uses such tools as interest rates, purchase and sale of government securities and control of cash movements. Central banks can influence the interest rates by changing the base rate (discount rate) for short-term rates. An increased based rate means the cost of borrowing increases, and the banks will charge high rates for their loans. The resultant effect is increased cost of borrowing which deters customers from getting loans, and the money in circulation goes down.