Central Banks

Floating vs. Fixed Exchange Rates

There are two types of exchange rate systems: floating or fixed. A floating exchange rate is one in which a currency’s value is determined by market forces. A fixed exchange rate matches, “pegs”, the value of the currency to: one currency, several currencies or even to a fixed amount of a commodity.

Floating Exchange Rates Prior to 1971’s breakdown of the Bretton Woods Agreement (a fixed exchange rate system revolving around the US Dollar and gold), most currencies were pegged. Today, the current international financial system squares most of the currencies of the world against one another in a free market. Floating exchange rates are preferable to fixed ones since floating rates are reflective of market movement and the principles of supply and demand and limit imbalances in the international financial system. Fixed exchange rates grant more control to central banks (who may or may not be independent of the government) to set a currency’s value, and during times of volatility are preferred for their greater stability. Many developing countries use fixed exchange rates in order to evade market abuse.

In extreme situations such as political unrest, terrorist attacks or natural disasters a country’s currency may experience a period of heavy selling that causes it to depreciate in value. The country’s central bank may intervene in order to restore the value of the currency. A central bank regime that routinely intervenes would use the term "managed float". Sometimes, the central bank may set upper and lower bounds known as price ceilings and floors, respectively, and intervene whenever those bounds are reached.

Central Banks, Interventions, and Interest Rates

Central banks influence the supply and demand of their country’s currency through control of interest rates or though intervention actions.

For many large economies, central banks can influence their currency’s value by changing interest rates. The US central bank, the Federal Reserve, is not necessarily trying to achieve a weak or strong dollar policy, but acts in a manner that curbs inflationary pressure while maintaining steady growth within the economy. It uses interest rates as a mechanism to achieve this type of economic state. Our next lesson explains more about interest rates and central banks.

The other method used by banks to influence supply and demand of its currency deals with directly buying or selling currencies through its reserves (as was explained above). An example of such operation can be seen by the Reserve Bank of China. Suppose the Reserve Bank of China thinks that the Chinese Yuan had appreciated too much and wanted to lower its value. Then, the Reserve Bank of China will sell its yuan and buy another currency such as the Japanese Yen into its reserves. The increased supply of yuan should work to lower the yuan’s exchange rate.

Although this provides a convenient way for the central banks to control the value of their currency, the banks must be careful. There is only a limited amount of currencies that each country has within its reserves and a prolonged attempt to fight market forces can deplete it causing a financial crisis.

A central bank can affect the demand for other countries currency as well. If the bank (Russian Central Bank) feels that its reserve amount of a particular country’s currency (Euro) is too low then it will engage in the foreign exchange market and buy that currency. This change in the composition of the Russian central banks reserves, will lead to an increase in demand of the Euro since it is being bought, and the Euro’s appreciation.

Lesson 5 explains the role of central banks in setting a country’s interest rates. It discusses the effects that investment and inflation play in officials’ decisions. We will also give an example of the Forex market’s reaction to central banks’ actions and expectations.