Role of central bank in exchange rate determination | Commerce Study Notes

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Role of central bank in exchange rate determination

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
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

                                              Read NFBS CONCEPT Full Notes                                          

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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