Exchange rates are an essential part of a country’s economy – they are an indicator of whether a country is thriving or struggling. Have you ever thought about a bank’s role in the exchange rate? Central banks work to regulate and manage a country’s currency to keep the economy ticking and work in a way that keeps the currency strong. Read on as we find out more about how central bank control exchange rate.
Why is the exchange rate important?
The exchange rate determines how much it costs to change one currency to another. There are many reasons why investors and businesses need to keep a close eye on the exchange rates – the rise and fall of exchange rates can have an impact on how businesses trade with one another and can be impacted by economic growth or instability, inflation, or other types of economic activity. If businesses often trade using the Forex market, they must do all they can to keep up with changes in the economy of the country they’re trading with, as well as any issues that may be having an impact on the exchange rate, so that they can get the best deal, and reduce the chance of a loss occurring.
What is a Central bank?
Before we can take a look at how they impact our finances when it comes to currency exchange, it is useful to know what a central bank is. A Central bank is autonomous – they help countries worldwide to manage commercial banking. When a country uses a central bank, investor confidence within that country, and from other countries increases, as they help to manage financial stability, meaning governments are more likely to pay off their debts. So, what role do they play when it comes to our finances?
How do they impact our finances?
Central banks in countries all over the world have an impact on our finances in ways that you may not even have thought of. There are three main factors that central banks help to control; they are:
- Market regulation: Central banks help to regulate the overall economic activity within a country. They establish interest rates to help economies that are suffering from high rates of inflation by increasing interest rates or lowering them when borrowing within the country is low.
- Currency reserves: Another way that central banks impact our finances is by managing a country’s currency. They ensure that there is enough supply being circulated and must ensure that there is a sufficient investment between trading countries to keep their currency strong and thriving.
- National currency: Have you ever wondered where money in your pocket comes from? Central banks must print currency and ensure there is ample supply within the economy.
How do they manage exchange rates?
It is a Central bank’s job to do all it can to stabilise the currency of a country. An unstable currency may mean that imports become more expensive, and exports become cheaper to buy for other countries, which can have an impact on the country’s economy as a whole. Here are a few ways in which a Central bank manages the exchange rates within a country.
Interest rates
As we’ve seen above, Central banks manage interest rates depending on how the economy within a country is progressing – increasing interest rates to help manage inflation and lowering them when the borrowing within a country has slowed down. When banks decide to increase interest rates, investors will drive the demand for currency up, as they take advantage of the high-interest rates. If a Central bank lowers these rates, demand for currency tends to drop, as investors become less interested in a currency that has low-interest rates.
Buying and selling
This is another way in which Central banks help to manage currency exchange rates. Banks in a country perform an intervention in the form of buying and selling currency in the exchange market. The Central bank can increase the demand for a currency by buying it, which as a result strengthens the exchange rate overall. If the bank chooses to intervene in the market by selling currency, it reduces demand, resulting in a weaker currency and exchange rate. Central banks may also use a currency peg which helps to stabilise a currency and set a fixed exchange rate between currencies.
Examples of Central Banks
There are a few Central banks all over the world that are essential when it comes to the economy, and because they are important, the way that they trade carries weight with other countries – in other words, their opinion matters! Some of the most important Central banks are the ECB, which is the European Central Bank, which includes governors from 19 Eurozone countries. The US Federal Reserve System is based in the United States and is arguably the most important and powerful Central bank in the world. The Bank of Japan and the Bank of Canada are also some of the most influential, to name a few of the most important.
