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

In a regime of , how might a Central Bank operate its monetary policy and its policy for intervention in foreign exchange markets? Why does it need foreign exchange reserves? The last 20 years have seen an increased international interdependence due to the reduction in the controls on capital flows between countries have been much reduced. Also, since the early 1970's, many countries have permitted much more flexibility in their exchange rates. These developments have raised several issues: how does the exchange rate regime affect the efficacy of domestic monetary and fiscal policies undertaken by small, open economies? In response to this question, many analysts such as exchange rate and balance of payment using IS-LM model, have contributed to the rapid development of the open economy models. An exchange rate regime is a description of the conditions under which national government allow exchange rate to be determined. There are three types of exchange rates, fixed, flexible and managed exchange rate. In a fixed exchange rate regime, national governments agree to maintain the convertibility of their currency at a fixed exchange rate.

A currency is convertible if the government acting through the central bank, agrees to buy or sell as much of the currency people wish to trade at the fixed exchange rate. Most central banks act as the government's banker, the Banks' bank, lender of last resort and issuer of notes as well as supervising the banking system and operating monetary policy. Monetary policy refers to the attempts to manipulate the interest rate and the money supply so as to bring about desired changes in the economy. The aims of monetary policy are the same as those of economic policy generally. They are the maintenance of full employment, price stability, a satisfactory rate of economic growth, and a balance of payments equilibrium. Under a fixed exchange rate regime, governments are committed to intervention in the foreign exchange market to maintain a given nominal exchange rate. It is important by the central bank to intervene in order to buy or sell the foreign exchange in the open market economy. It is very apprehensible that foreigners would buy assets in any country they choose, quickly, with low transactions costs, and in unlimited accounts due to the perfect capital mobility.

Perfect capital mobility means that the government cannot fix independent targets for both the money supply and the exchange rate. This also implies that any one country's interest rates cannot get too far out of line without bringing about capitals flows that tend to restore yields to the world level. Under fixed exchange rates, the government has to accept the domestic money supply that makes domestic and foreign interest rates equal. It is comprehensible from the above statement and also by looking at the Mundell-Fleming theorem, that there will be an extreme capital flows if there is even a slight change in interest rates. Therefore, with perfect capital mobility, central banks cannot conduct an independent monetary policy under fixed exchange rate. For example, if a country increases its interest rate by tightening its monetary policy. Immediately, investors shifts their wealth to take advantage of the new rate and so therefore the result would be a massive capital inflow.

The balance of payment will now show a gigantic surplus; foreigners try to buy domestic assets, tending to cause the exchange rate to appreciate, and forcing the central bank to intervene to hold the exchange rate constant. It buys the foreign money, in exchange for domestic money. This intervention takes place until the interest rates are back in line with those in the world market. When price adjustment is slow, an increase in the nominal money supply increases the real money supply in the short run, and tends to reduce domestic interest rates. With perfect capital mobility, this leads to a capital account outflow until the domestic money supply has been reduced to its original level and interest rates have returned to world levels. Hence domestic policy is powerless in a fixed exchange rate regime when capital mobility is perfect. By looking at this point in terms of the open economy IS-LM model. Figure 1, shows that under perfect capital mobility the balance of payments can be in equilibrium only at the interest rate. At even the slightly higher or lower interest rate, the capital flows are so massive that the balance of payments cannot be in the equilibrium, and the central bank has to intervene to maintain the exchange rate. The intervention shifts the LM curve.

Due to the monetary expansion's decrease in interest rate and so the economy moves from E to E'. But at E' there is a large payments deficit pressure on the exchange rate. Therefore, the central bank must intervene, selling foreign money and receiving domestic money. Therefore, the LM curve shifts back up to its initial point E. Indeed, with perfect capital mobility the economy never ever gets to point E'. The response of the capital flow is so large and rapid that the central bank is forced to reverse the initial expansion of the money stock as soon as it attempts it. So this proves that the monetary policy under fixed exchange rate regime is totally ineffective. However the fiscal policy is very effective under fixed exchange rate regime. With the money supply unchanged, it moves the IS curve up and to the right, tending to increase both the interest rate and the level of output. The higher the interest rate sets off a capital inflow that would lead the exchange rate to appreciate. In order to maintain the exchange rate, the central bank has to expand it's money supply by increasing the income further.

As in figure 2, the equilibrium is restored when the money supply has increased enough to drive the interest rate to its initial position. The monetary policy is effective when it is under flexible exchange rate regime. From figure 3, we can see the actual intervention by the central bank in the foreign money market. Here the dollar-pound exchanged rate is fixed at e1. The fixed exchange rate, e1, would be the equilibrium rate if the supply curve were SS and the demand curve DD. With neither an excess supply of pound nor an excess demand for pounds, nobody would want to buy or sell pounds to the central bank. The market would clear on its own. When demand for pounds in DD1, there is an excess demand AC.

The bank of England intervenes by supply AC pounds in exchange for dollars, which are added to the UK foreign exchange reserve. The foreign exchange rate reserves are the stock of foreign currency hold by the domestic central bank. When demand is DD2, the foreigners would buy less of British goods which will decrease the demand for pound. The bank sell off some of the foreign exchange reserves in exchange for pounds. It demands EA pounds to offset the excess supply EA at the exchange rate e1. When demand is DD, the market clears at the exchange rate e1 and no intervention by the bank takes place. Fixed exchange rate operates like any other price support scheme. Given market demand and supply, the price fixer has to make up the excess demand or take up the excess supply. In order to maintain the fixed exchange rate, it is necessary to hold on to the foreign exchange, that can be provided in exchange for the domestic currency.

As long as the central bank has the necessary reserves; it can continue to intervene in the foreign exchange market in order to keep the exchange rate constant. However, if a country persistently runs deficits in the balance of payments, the central bank eventually will run out of reserves of foreign exchange and will be unable to continue its intervention. Usually even before this point is reached, the central bank is likely to decide that it can no longer maintain the exchange rate, and will then devalue the currency. For instance, in 1967 the British devalued the pound from $2.80 per pound to $2.40 per pound, which meant that the pound became cheaper for the foreigners to buy and the devaluation thus affected the balance of payment by making British goods relatively cheaper.

A devaluation is a reduction in the exchange rate which the government commits itself to defend. Under fixed exchange rates and perfect mobility, monetary policy is powerless to affect output. If we try to reduce the domestic interest rate by increasing the money stock would lead to a huge outflow of capital, which will cause a depreciation, central bank would have to buy domestic money in exchange for foreign money. This will reduce the domestic money stock until it returns to its original level. Fiscal policy is highly effective in this case, a fiscal expansion will raise the interest rate, leading the central bank to increase the money stock to maintain the exchange rate constant, reinforcing the expansionary fiscal effect. Under fixed exchange rate, the central bank holds constant the price of foreign currencies in terms of the domestic currency by buying and selling foreign exchange. This is the reason for keeping foreign exchange reserves.