I.
FUNDAMENTALS OF Role of central
bank in exchange rate determination
Central bank play very important role in exchange rate
system. it link between the world economy. it also control the exchange rate fluctuation.
so role of central bank in exchange rate determination is very
important
A. Role of
central bank in exchange rate determination
- LINKS BETWEEN THE DOMESTIC
- THE WORLD ECONOMY
B. THE IMPACT
OF EXCHANGE RATE CHANGES
1. Currency
Appreciation:
- Domestic prices increase relative
to foreign prices.
- Exports: less price competitive
- Imports: more attractive
2. Currency
Depreciation
- - domestic prices
fall relative to foreign prices.
- - Exports:
more price competitive.
- - Imports: less
attractive
C. Foreign
Exchange Market Intervention
1.
Definition: the official purchases and sales of currencies
through the central bank to influence the home exchange rate
2. Goal of
Intervention: - to alter the demand for one currency by
changing the supply of another.
D. The Effects of Foreign Exchange Intervention
1. Effects of Intervention - either ineffective or
irresponsible
2.
Lasting Effects - If permanent, change results
The major role of central bank
in exchange rate determination is to maintain the value of its currency. It can
do this two ways.
1) Domestic monetary
policy: controlling domestic inflation and interest rates. n
2) International policy:
helping to maintain ‘stable’ exchange rates.
3)The central bank is, in
theory, the only government agency that can “print” new money. New money is
usually ‘transmitted’ to the private sector through a process called
monetization.
4)Monetization is what
happens when a government bond is converted to currency in circulation.
The process of monetization in role
of central bank in exchange rate determination
1) If the Treasury needs to borrow to fund a budget deficit,
it issues new Treasury debt. If the Treasury issues too much, interest rates
could rise sharply, “crowding out” private borrowers.
2) The central bank may, if it doesn’t wish private-sector
interest rates to rise, purchase some of the Treasury’s outstanding debt.
n
3) The bank pays the seller or issuer of those bonds with
what is essentially new money (fiat money).
4) Clearly, if the Central bank buys up a lot of the debt,
it will be essentially “printing” a lot of new money. The monetary base
balloons and domestic inflation may increase.
- A
Central Bank that is closely-linked to the ruling government may have a
tendency to monetize deficits for political reasons.
- Weak
governments usually have a severe problem with excessive money creation. n
Weak governments have trouble collecting taxes
-
Weak governments resort to excess spending on government jobs, a large
military, lavish pensions to maintain popularity.
- Thus,
the budget goes deeply into deficit.
- The
government has to borrow, issuing bonds, to raise the difference between
spending and tax revenues.
- As
the Central Bank often ends up being the only buyer of the government
bonds, these weak governments usually have a severe problem with excessive
money creation.
- Argentina
(earlier Hong Kong) dispensed with its irresponsible central bank and
tried to use a currency board: Argentine pesos were backed (one to
one) by USDs held by the Board. The board wasn’t supposed to “print” more
pesos than it had dollars.
This is the full chapter of role of central bank in exchange
rate determination. the chances of this type question in mcom
exams is very high. this full study note. you do not study extra. This is
enough content.
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