THE ROLE OF CENTRAL BANKS

Despite the size and importance of the foreign exchange market, it remains largely unregulated. There is no international organization that supervises it, nor any institution that sets rules. However, since the advent of flexible exchange rates in 1973, governments and central banks, such as the Federal Reserve System in the United States, periodically act to maintain stability in the FX market.

There is no standard definition of instability or a disorderly market—circumstances must be evaluated on a case-by-case basis. Sharp, rapid fluctuations of exchange rates and traders' reluctance to be ready to either buy or sell currencies (maintaining a "two-way" market) may be signs of a disorderly market. In these cases, central banks often work together to restore stability. However, a country taking a very conservative view toward market intervention would act only in response to unusual circumstances that require immediate action, like political unrest or natural disasters.

The monetary authorities would be less likely to try to counteract the usual fundamental factors that drive exchange rates, such as trade patterns, interest rate differentials and capital flows.

INTERVENTION

The U.S. Treasury, which has overall responsibility for managing the U.S. government's foreign currency holdings, works closely with the Federal Reserve to regulate the dollar's position in the FX markets. If the monetary authorities decide that it would be desirable to strengthen or weaken the dollar against a particular currency, instructions are given to the Federal Reserve Bank of New York, which intervenes in the FX market as agent for the U.S. monetary authorities. The Federal Reserve Bank of New York buys dollars and sells foreign currency to support the value of U.S. dollars, or sells dollars and buys foreign currency to try to exert downward pressure on the price of the dollar. Most of the transactions the Fed engages in involve the exchange of dollars for either German marks or Japanese yen, the most frequently used currencies in international transactions.

Central banks in other countries have similar concerns about their own currencies and sometimes intervene in the FX market as well. Usually, intervention operations are undertaken in coordination with other central banks. The amount of intervention, from tens of millions to a few billion dollars, is not a great deal in a market whose size sometimes exceeds $ 1 trillion per day. The actual purchase or sale of currency by a central bank has the same impact on the supply or demand for currency as the actions of any other market participant. However, the actions of central banks send strong signals to other market participants about what the country's monetary authorities think about the value of the currency; the resulting expectation that the country's economic policy will move in a certain direction can influence trading.

Most of the Federal Reserve Bank of New York's activity in the foreign exchange market is undertaken for far less dramatic purposes than to influence exchange rates. The Bank often deals in the foreign exchange market as an agent for other central banks and international organizations to execute transactions related to flows of international capital.

Some countries have special arrangements with other countries to help keep their currencies stable. Many less-developed nations have their soft currencies pegged to hard currencies, which means their value rises and falls simultaneously with the stronger currency. Some peg their currencies to a basket of hard currencies, the average of a group of selected currencies. Those countries that choose to tie their currency to a single currency usually use the U.S. dollar or the French franc. Some European countries are part of an agreement called the European Monetary System (EMS), which requires them to keep their currencies within a certain price range. When currencies move too high or too low relative to other currencies in the EMS, central banks act to try to keep the currency within the range.

Intervention in the FX market is not the only way monetary authorities can affect the value of their country's currency. Central banks also can affect foreign exchange rates indirectly by influencing their countries' interest rates. Relatively high interest rates tend to push the price of a currency up because investors may want to buy the currency to invest at the higher rates. If Germany's interest rates rise to eight percent while those of the United States are at three percent, demand for the German mark will be stimulated. A reduction in interest rates would lessen demand for the currency and its price would tend to fall. In addition, if a central bank's policies are viewed by the market as promoting stable growth without inflation, the currency will be viewed as a safe investment, and demand for it will increase.

Date: 2015-12-24; view: 882