Monetary policy: impact on exchange rates

Monetary policy: impact on exchange rates

What is a central bank?

It is worth to start from the small definition. A central bank is a sovereign national bank that operates independently of the government and influences monetary policy. It also acts as a bank for other nations’ commercial banks.

The main aim of the central bank is to maintain price stability by controlling inflation and create the stable economic environment for the country.

The central bank has an important feature. It is the only legal financial institution that is allowed to print money as a legal tender. Printing money the central bank has opportunities to control the money supply, the total amount of money available in the economy. Using this feature the central bank regulates the inflation level and the economic environment of the country.

Monetary policy

Let’s talk about the monetary policy which central banks use to control inflation.

To control the level of inflation banks can use one of two monetary policy types: accommodative or restrictive.

  • Accommodative/ loose/ expansive monetary policy

mon pol.png

If GDP growth is low, a central bank increases money supply in the country. The central bank decreases interest rates achieving an economic growth and lower inflation. Business investments and consumer spending rise because of cheaper borrowing. Implementing such policy, the bank creates conditions for the economic growth but affects the domestic currency.

Because of low real interest rates, foreign investors won’t hold financial and capital assets in the country, and domestic investors will look for more appealing rates of return abroad as well. The decline in investments will lead to the decline in demand for domestic currency. The domestic currency will depreciate versus foreign currencies.

Making a conclusion about the accommodative monetary policy, it can be said that when the central bank implements such policy it leads to the growth of domestic economy but has a harmful impact on the national currency.

  • Restrictive/ tight/ contractionary monetary policy

mon pol 2.png

When the amount of money is huge, the central bank raises interest rates to reduce the money supply and decrease the inflation level. High interest rate gives a limited ability to businesses and households to borrow. Domestic consumers are at a loss. However, raising interest rates, the central bank creates conditions for investments. Foreign investors tend to hold more domestic assets. As a result, the balance on nation’s capital account improves. Domestic investors will invest in their own country as well. The high level of the investments will lead to the rise of the domestic currency thus its exchange rate will increase.

To conclude, implementation of the restrictive policy affects domestic businesses and households because of the high level of interest rates and the lack of opportunities to borrow, but it strengthens the national currency.

Conclusion: Why should traders pay attention to the central bank policy?

Coming back to the main question of this note, let’s sum up why it is so important for traders to take into account the policy of central banks.

To simplify the explanation, let’s consider an example. When one central bank has lower interest rates and keeps them so for a long period of time, traders can look for a central bank that has an opposite policy – increases interest rates. Traders can keep money in the currency of the second central bank with the higher interest rate to get a higher return or they can borrow money from the first bank with the lower interest rate and then use it to fund investments in the other currency.

Another important fact is that the currency of the country where the central bank implements the restrictive monetary policy is more stable and the economy of the country is healthier than of the country with the accommodative monetary policy.

As a result, the currency with a higher central bank’s interest rate will appreciate against a currency, the central bank of which has a lower interest rate.

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