Should The Federal Reserve Intervene In Foreign Exchange Markets?
The simultaneous targeting of the money supply and interest rates is not possible independently, as money supply defines interest rates.
The money supply is connected to interest rates. If the Federal Reserve increases interest rates, the demand for loans will decline. Hence the rate of the money supply through the banking system will decline as fewer money will be pushed into the system. When the Federal Reserve increases rates adequately to diminish the demand, the supply will be tightening up as demand falls. For instance, when people are taking car loans, in case rates are higher, fewer people will be attracted by expensive cars because they will not be able to meet the expense of the monthly payments. Therefore, they will acquire less expensive cars
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By adjusting interest rates, Federal Reserve reins how much demand there is for an increase in the monetary supply. o How central banks intervene in foreign exchange markets?
"A foreign exchange intervention is a monetary policy tool in which a central bank takes an active participatory role in influencing the monetary funds transfer rate of the national currency."
(Investopedia, 2017)
There are many motives why a country's fiscal authority may want to intervene in the foreign exchange market, for example, to build reserves, stabilize the exchange rate and to correct misalignments. The chief objective of foreign exchange market intervention is to control the volatility and influence the level of the exchange rate.
According to Investopedia: “a sterilized intervention is the purchase or sale of foreign currency by a central bank to influence the exchange value of the domestic currency, without changing the monetary base.” (Investopedia, 2017)
Here the example of sterilized intervention. Let us assume that the Federal Reserve is worried about the weakness of the dollar against the Canadian Dollar. It, therefore, sells CADdenominated bonds in the sum of CAD 1 billion, and it receives $800 million in proceeds
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