Goals of Monetary Policy
The goals of a country’s monetary policy include:
- Controlling inflation
- Achieving full employment
- Regulating the pace of economic growth
- Responding to cyclical fluctuations in the economy
- Ensuring stability and managing the balance of payments
Tools of Monetary Policy
- Adjusting reserve requirements
Adjusting reserve requirements is a powerful tool used by the central bank to conduct monetary and credit regulation. The credit capabilities of commercial banks are largely determined by the amount of reserves that commercial banks must keep on accounts with the central bank. A commercial bank can only provide loans if it has sufficient funds beyond this reserve. Therefore, by reducing or increasing its requirements for the reserve size, the central bank regulates the credit activities of commercial banks, thus influencing the money supply.
- Open market operations
Open market operations are another tool of monetary and credit regulation. The main method when using this tool involves the central bank buying and selling government securities. By purchasing securities on the open market, the central bank increases the liquidity of commercial banks, encouraging lending. Selling securities leads to the opposite effect.
Another type of open market operation includes foreign exchange interventions. The central bank of the country sells or buys a certain amount of currency from its gold and foreign exchange reserves, thereby weakening or strengthening the national currency exchange rate.
- Adjusting interest (discount) rates
Interest or discount rate is the percentage at which the central bank lends to commercial banks. By increasing or decreasing the level of the interest rate, the central bank regulates the cost of loans, thus affecting the ability of commercial banks to lend to businesses and the population. Changes in the interest rate also affect the exchange rate of the national currency. An increase in the interest rate causes an inflow of funds into the national currency and is considered a risk-free investment by investors.
Types of Monetary Policy
In the modern financial world, monetary policy is divided into two types: soft (‘dove’) and hard (‘hawk’) monetary policy.
- Soft Monetary Policy
Soft monetary policy is characterized by a gradual decrease in the central bank’s interest rate and maintaining it at these levels for a long time, as well as using unconventional methods (such as a series of QE programs by the US Federal Reserve, LTRO programs, and quantitative easing by the European Central Bank).
Soft monetary policy aims to stimulate the economy of the country through cheaper financing, fighting deflationary processes, and accelerating inflation to certain target levels, but it leads to a depreciation of the national currency. Followers of soft monetary policy are called ‘doves,’ and the policy itself is referred to as ‘dove’ policy.
- Hard Monetary Policy
Hard monetary policy is characterized by a consistent increase in the central bank’s discount rate. Central banks of countries with stable economies implement hard monetary policy, as this policy requires increased financial system resilience. Increasing interest rates also leads to an appreciation of the national currency. Followers of hard monetary policy are called ‘hawks,’ and the policy itself is referred to as ‘hawk’ policy.
How Monetary Policy Affects Currency Exchange Rates on Forex
Classic fundamental analysis assumes that the exchange rate of the national currency rises with an increase in the interest rate (risk-free investment – the higher the interest rate, the higher the return for an investor who invests money in the country’s economy) and falls with a decrease in the discount rate (the income from investments is minimal and not attractive to investors).
On the foreign exchange market, there is a concept called divergence (difference) in monetary policies. For example, in 2014, the US Federal Reserve announced the start of a process of tightening monetary policy, while the European Central Bank declared its intention to ease its monetary policy. As a result, the EUR/USD currency pair fell throughout the second half of 2014.
Foreign exchange interventions conducted by the central bank have a significant impact on currency pair exchange rates. For example, in 2014, the Russian Central Bank used interventions to prevent the ruble from depreciating, and until the end of July 2015, the Bank of Russia purchased 200 million dollars daily to replenish its reserves, thus preventing the ruble from appreciating.
Among traders, the Swiss National Bank (SNB) is well known for regularly conducting interventions to weaken the Swiss franc, which is popular as a safe-haven currency. For example, the SNB’s foreign exchange intervention on September 6, 2011, caused a rise in the USD/CHF pair by almost 800 points in one trading day.
Also, the statement by the central bank about choosing a particular method of setting the exchange rate of the national currency and warnings about intentions, also known as verbal interventions, strongly affects the exchange rate of the currency. For example, the announcement by the Bank of Russia about abandoning the regulation of the ruble exchange rate was called ‘free float’ and led to the depreciation of the Russian currency. The announcement by the Federal Reserve about the intention to raise the interest rate caused the dollar to strengthen, and the abandonment of the Swiss franc’s peg to the euro by the SNB caused the EUR/CHF pair to drop more than 2000 points in one day, becoming the cause of bankruptcy announcements by several forex brokers.
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FAQ
What is monetary policy?
Monetary policy refers to the actions taken by a central bank to manage the money supply and interest rates to influence economic activity and maintain stability.
How do central banks affect currency exchange rates?
Central banks influence exchange rates through interest rate changes, open market operations, and foreign exchange interventions, which impact investor behavior and currency demand.
What are the types of monetary policy?
There are two main types: soft (dove) policy, which aims to stimulate the economy, and hard (hawk) policy, which focuses on controlling inflation and stabilizing the currency.
