How Central Bank Operate Its Monetary Policy and Their Role in Intervention in Foreign Exchange Markets

Introduction

In a fixed exchange rate regime, central banks play a crucial role in maintaining currency stability through monetary policy and foreign exchange interventions. The increased international interdependence over the last two decades has significantly reduced controls on capital flows, leading to a more flexible exchange rate system in many countries.

Types of Exchange Rate Regimes

An exchange rate regime defines how governments allow their currencies to be determined. There are three primary exchange rate systems:

• Fixed Exchange Rate: Governments maintain a constant currency value against another currency.
• Flexible Exchange Rate: Market forces determine the currency value.
• Managed Exchange Rate: A hybrid system where central banks intervene occasionally.

The Role of the Central Bank

Central banks act as the government's banker, lender of last resort, and regulator of the banking system. Their primary goals include maintaining price stability, achieving full employment, fostering economic growth, and ensuring balance of payments equilibrium.

Foreign Exchange Market Interventions

Under a fixed exchange rate system, the central bank intervenes by buying or selling foreign currencies to maintain stability. This intervention can involve:

• Buying foreign currency: To prevent domestic currency appreciation.
• Selling foreign currency: To prevent domestic currency depreciation.

Perfect Capital Mobility and Its Implications

Perfect capital mobility implies that investors can freely move assets across borders with minimal transaction costs. As a result, a country's interest rate cannot deviate significantly from global rates without triggering capital flows. The Mundell-Fleming model illustrates how monetary policy is ineffective in a fixed exchange rate regime due to immediate capital inflows or outflows in response to interest rate changes.

Impact on Balance of Payments

When a country raises interest rates, foreign capital inflows lead to a balance of payments surplus. To maintain exchange rate stability, the central bank must purchase foreign currency, increasing the domestic money supply. Conversely, if interest rates decline, capital outflows create a deficit, requiring the central bank to sell foreign reserves.

Fiscal Policy Under Fixed Exchange Rates

Unlike monetary policy, fiscal policy remains effective under fixed exchange rates. Government spending increases shift the IS curve, raising output and interest rates. Capital inflows then require the central bank to expand the money supply, further stimulating economic growth.

Foreign Exchange Reserves

Foreign exchange reserves are crucial for central banks to sustain exchange rate stability. They enable the bank to intervene in markets and maintain investor confidence. However, persistent deficits can deplete reserves, forcing currency devaluation, as seen in the 1967 British pound devaluation.

Conclusion

In a fixed exchange rate regime with perfect capital mobility, monetary policy is ineffective, while fiscal policy remains powerful. The central bank's primary tool for maintaining currency stability is intervention in foreign exchange markets, necessitating the accumulation of substantial reserves.

References

• Mundell, R. (1963). Capital Mobility and Stabilization Policy under Fixed and Flexible Exchange Rates.
• Fleming, J. (1962). Domestic Financial Policies under Fixed and Floating Exchange Rates.
• Bank of England (1967). The British Pound Devaluation.
• International Monetary Fund (2021). Exchange Rate Policies and Central Bank Interventions.