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Types of Currency Regimes Fixed Currency Fixed Currency or Dollarization occurs when one country uses another nation's currency as a medium of exchange, inheriting the credibility of that country's currency, but not its creditworthiness. This approach can impose fiscal discipline. Monetary Union Monetary Union or Currency Union occurs when several countries share a common currency.
As with dollarization, such a regime fails to impose creditworthiness as some nations' finances are more profligate than other nations. Examples are the eurozone current and Latin and Scandinavian monetary unions defunct. Currency Board Currency Board is an institutional arrangement to issue a local currency backed by a foreign one.
Hong Kong is a prime example. This imposes fiscal discipline, but the HKMA may not act as a lender of last resort, unlike a central bank. There is no legislative commitment to parity and there is a discretionary foreign exchange reserve target. Examples are Argentina, Venezuela, and Russia. Examples here include the Slovak Republic and Syria. Exchange rates would be adjusted to keep pace with inflation rates and prevent a run on U.
An active crawl entailed announcing the exchange rate in advance and implementing changes in steps, to manipulate inflation expectations. Other examples include China and Iran. Fixed Parity with Crawling Band Fixed Parity with Crawling Band is a fixed parity arrangement with greater flexibility to allow exit from fixed parity or afford the monetary authority greater latitude in policy execution, such as in Costa Rica.
Managed Float Managed Float or Dirty Float occurs when a nation follows a policy of loose intervention to achieve full employment or price stability with an implicit invitation to other countries with which it conducts business to respond in kind. Independent Float Independent Float or Floating Exchange is evident when exchange rates are subject to market forces.
The monetary authority may intervene to achieve or maintain price stability. Examples are the U. History of Currency Regimes Currency regimes may be both formal and informal. The former entails a treaty and conditions for membership in them.
These may entail a limit on the candidate nation's sovereign debt as a percentage of gross domestic product or its budget deficit. These were conditions of the Maastricht Treaty of during the long march to the ultimate formation of the euro. The currency peg system is somewhat less formal. Indeed, the aforementioned regimes form a continuum and monetary authorities have made policy decisions that could fall into more than one of these categories regime change.
Think of the mids Plaza Accord taken to lower the U. This is conduct atypical of a free-floating currency regime. Currency regimes have been formed to facilitate trade and investment, manage hyperinflation or form political unions.
With a common currency, ideally, member nations sacrifice independent monetary policy in favor of a commitment to overall price stability. Political and fiscal unions are typically prerequisites to a successful monetary union where, for example, olive oil is manufactured in Greece and shipped to Ireland without the need for importers or exporters to employ hedges to lock in favorable exchange rates to control business costs.
While the unending to-and-fro of the European Monetary Union plays out on a daily basis, the history of currency regimes has been a checkered one, marked by both success and failure. The lack of a sole central bank with an attendant monetary policy proved to be the union's undoing.
So, too, did the fact that the union's member treasuries minted both gold and silver coins with a coinage restriction per capital and a lack of uniformity in metal content that caused price pressures on the two precious metals and a lack of free circulation of the specie. However, by World War I, the union was effectively finished. An exchange rate mechanism is not a new concept. Historically, most new currencies started as a fixed exchange mechanism that tracked gold or a widely traded commodity.
It is loosely based on fixed exchange rate margins, whereby exchange rates fluctuate within certain margins. An upper and lower bound interval allows a currency to experience some variability without sacrificing liquidity or drawing additional economic risks. The concept of currency exchange rate mechanisms is also referred to as a semi-pegged currency system. It was designed to normalize exchange rates between countries before they were integrated in order to avoid any problems with price discovery.
On September 16, , a day known as Black Wednesday, a collapse in the pound sterling forced Britain to withdraw from the European exchange rate mechanism ERM. The exchange rate mechanisms came to a head in when Britain, a member of the European ERM, withdrew from the treaty. Real World Example: Soros and Black Wednesday In the months leading up to the event, legendary investor George Soros had built up a monumental short position in the pound sterling that became profitable if the currency fell below the lower band of the ERM.
Soros recognized that Britain entered the agreement under unfavorable conditions, the rate was too high, and economic conditions were fragile. In September , now known as Black Wednesday , Soros sold off a large portion of his short position to the dismay of the Bank of England, who fought tooth and nail to support the pound sterling.
The European exchange rate mechanism dissolved by the end of the decade, but not before a successor was installed.
Expansionary During times of slowdown or a recession , an expansionary policy grows economic activity. By lowering interest rates, saving becomes less attractive, and consumer spending and borrowing increase. Goals of Monetary Policy Inflation Contractionary monetary policy is used to target a high level of inflation and reduce the level of money circulating in the economy.
Unemployment An expansionary monetary policy decreases unemployment as a higher money supply and attractive interest rates stimulate business activities and expansion of the job market. Exchange Rates The exchange rates between domestic and foreign currencies can be affected by monetary policy. With an increase in the money supply, the domestic currency becomes cheaper than its foreign exchange.
Tools of Monetary Policy Open Market Operations In open market operations OMO , the Federal Reserve Bank buys bonds from investors or sells additional bonds to investors to change the number of outstanding government securities and money available to the economy as a whole. The objective of OMOs is to adjust the level of reserve balances to manipulate the short-term interest rates and that affect other interest rates.
Interest Rates The central bank may change the interest rates or the required collateral that it demands. In the U. Banks will loan more or less freely depending on this interest rate. Reserve Requirements Authorities can manipulate the reserve requirements , the funds that banks must retain as a proportion of the deposits made by their customers to ensure that they can meet their liabilities. Lowering this reserve requirement releases more capital for the banks to offer loans or buy other assets.
Increasing the requirement curtails bank lending and slows growth. Monetary Policy vs. Fiscal Policy Monetary policy is enacted by a central bank to sustain a level economy and keep unemployment low, protect the value of the currency, and maintain economic growth. By manipulating interest rates or reserve requirements, or through open market operations, a central bank affects borrowing, spending, and savings rates. Fiscal policy is an additional tool used by governments and not central banks.
While the Federal Reserve can influence the supply of money in the economy, The U. Treasury Department can create new money and implement new tax policies. It sends money, directly or indirectly, into the economy to increase spending and spur growth.
Both monetary and fiscal tools were coordinated efforts in a series of government and Federal Reserve programs launched in response to the COVID pandemic. The Federal Open Market Committee of the Federal Reserve meets eight times a year to determine changes to the nation's monetary policies. Currency Exchange Rates Central banks of different nations have different policies and mandates as it relates to managing their currency.
The US dollar, for example, is a freely floating currency. This is to say that the exchange rate policy of the the Federal Reserve is to not directly engage in the management of the value of the Dollar. Rather, it sets specific policies and measures to achieve its dual mandate.
Countries such as China, on the other hand, actively manage their currency exchange rate. So what happens when a central bank such as the Federal Reserve decides to raise its interest rates. Well, we know from our earlier discussion that this will have the effect of curtailing growth within the US economy. When the Fed increases its interest rate, that often creates additional demand for the US dollar internationally. As a result, rising interest rates can have the effect of increasing additional demand for a currency, which in turn will cause its exchange-rate to rise as well against other currencies.
The flip side of this is when the Fed decides to reduce the current interest rate. Interest Rates One of the biggest drivers of foreign-exchange rates is the interest rates set by central banks. As such, Forex traders need to be cognizant of scheduled meetings and announcements of major central banks around the world. The decisions that central bankers make can influence the price of a currency pair both in the short term and over the longer term time horizon as well.
Many major currency pairs will become extremely volatile immediately following an interest rate decision. This is especially true if the central bank acts contrary to what was unexpected by major economists and analysts. The price of a currency pair can spike up or down hundreds of pips in an instant when such an event occurs.
And the ramifications of an interest rate policy, be it a rate hike or rate cut, can be felt for weeks and months, as investors around the world digest the new information. Money will often flow out of currencies that offer lower yield, and flow into currencies that offer higher yield. One popular strategy that many large hedge funds and institutions utilize in the foreign exchange market is the carry trade.
The carry trade seeks to purchase a currency with a high yield, and simultaneously sell a currency with a lower yield. The lower yielding currency is said to finance the higher-yielding currency. Another method that forex traders can implement is to try to predict future central bank policy decisions. Fundamental analysts study the underlying economic conditions for a specific country or region in an effort to gauge what monetary policymakers are likely to do in the future.
Conclusion Exchange rates of currency pairs fluctuate with different monetary policies, and the biggest factor influencing the forex market is interest rate changes made by central banks.
In the United States, the Federal Reserve Bank implements monetary policy through a dual mandate to achieve maximum employment while keeping inflation in check. Key Takeaways Monetary policy is a set of actions to control a nation's overall money supply and achieve economic growth. Monetary policy strategies include revising interest rates and changing bank reserve requirements. Monetary policy is commonly classified as either expansionary or contractionary.
The Federal Reserve commonly uses three strategies for monetary policy including reserve requirements, the discount rate, and open market operations. Economic statistics such as gross domestic product GDP , the rate of inflation , and industry and sector-specific growth rates influence monetary policy strategy.
A central bank may revise the interest rates it charges to loan money to the nation's banks. As rates rise or fall, financial institutions adjust rates for their customers such as businesses or home buyers. Additionally, it may buy or sell government bonds, target foreign exchange rates, and revise the amount of cash that the banks are required to maintain as reserves. Types of Monetary Policy Monetary policies are seen as either expansionary or contractionary depending on the level of growth or stagnation within the economy.
Contractionary A contractionary policy increases interest rates and limits the outstanding money supply to slow growth and decrease inflation, where the prices of goods and services in an economy rise and reduce the purchasing power of money. Expansionary During times of slowdown or a recession , an expansionary policy grows economic activity.
By lowering interest rates, saving becomes less attractive, and consumer spending and borrowing increase. Goals of Monetary Policy Inflation Contractionary monetary policy is used to target a high level of inflation and reduce the level of money circulating in the economy. Unemployment An expansionary monetary policy decreases unemployment as a higher money supply and attractive interest rates stimulate business activities and expansion of the job market. Exchange Rates The exchange rates between domestic and foreign currencies can be affected by monetary policy.
With an increase in the money supply, the domestic currency becomes cheaper than its foreign exchange. Tools of Monetary Policy Open Market Operations In open market operations OMO , the Federal Reserve Bank buys bonds from investors or sells additional bonds to investors to change the number of outstanding government securities and money available to the economy as a whole.
The objective of OMOs is to adjust the level of reserve balances to manipulate the short-term interest rates and that affect other interest rates. Interest Rates The central bank may change the interest rates or the required collateral that it demands.
In the U. Banks will loan more or less freely depending on this interest rate. Reserve Requirements Authorities can manipulate the reserve requirements , the funds that banks must retain as a proportion of the deposits made by their customers to ensure that they can meet their liabilities.
Brokers generally roll over their positions at the end of each day. Some of these trades occur because financial institutions, companies, or individuals have a business need to exchange one currency for another. For example, an American company may trade U. A great deal of forex trade exists to accommodate speculation on the direction of currency values.
Traders profit from the price movement of a particular pair of currencies. These represent the U. There will also be a price associated with each pair, such as 1. If the price increases to 1. Forex Lots In the forex market, currencies trade in lots called micro, mini, and standard lots. A micro lot is 1, units of a given currency, a mini lot is 10,, and a standard lot is , When trading in the electronic forex market, trades take place in blocks of currency, and they can be traded in any volume desired, within the limits allowed by the individual trading account balance.
For example, you can trade seven micro lots 7, or three mini lots 30, , or 75 standard lots 7,, How Large Is the Forex? The forex market is unique for several reasons, the main one being its size. Trading volume is generally very large. This exceeds global equities stocks trading volumes by roughly 25 times.
How to Trade in Forex The forex market is open 24 hours a day, five days a week, in major financial centers across the globe. This means that you can buy or sell currencies at virtually any hour. In the past, forex trading was largely limited to governments, large companies, and hedge funds. Now, anyone can trade on forex. Many investment firms, banks, and retail brokers allow individuals to open accounts and trade currencies.
When trading in the forex market, you're buying or selling the currency of a particular country, relative to another currency. But there's no physical exchange of money from one party to another as at a foreign exchange kiosk.
In the world of electronic markets, traders are usually taking a position in a specific currency with the hope that there will be some upward movement and strength in the currency they're buying or weakness if they're selling so that they can make a profit.
A currency is always traded relative to another currency. If you sell a currency, you are buying another, and if you buy a currency you are selling another. The profit is made on the difference between your transaction prices. Spot Transactions A spot market deal is for immediate delivery, which is defined as two business days for most currency pairs.
The business day excludes Saturdays, Sundays, and legal holidays in either currency of the traded pair. During the Christmas and Easter season, some spot trades can take as long as six days to settle. Funds are exchanged on the settlement date , not the transaction date. The U. The euro is the most actively traded counter currency , followed by the Japanese yen, British pound, and Swiss franc.
Market moves are driven by a combination of speculation , economic strength and growth, and interest rate differentials. Forex FX Rollover Retail traders don't typically want to take delivery of the currencies they buy.
They are only interested in profiting on the difference between their transaction prices. Because of this, most retail brokers will automatically " roll over " their currency positions at 5 p. EST each day. The broker basically resets the positions and provides either a credit or debit for the interest rate differential between the two currencies in the pairs being held. The trade carries on and the trader doesn't need to deliver or settle the transaction.
When the trade is closed the trader realizes a profit or loss based on the original transaction price and the price at which the trade was closed. The rollover credits or debits could either add to this gain or detract from it.
Since the forex market is closed on Saturday and Sunday, the interest rate credit or debit from these days is applied on Wednesday. Therefore, holding a position at 5 p. Forex Forward Transactions Any forex transaction that settles for a date later than spot is considered a forward. The price is calculated by adjusting the spot rate to account for the difference in interest rates between the two currencies. The amount of adjustment is called "forward points.
They are not a forecast of how the spot market will trade at a date in the future. A forward is a tailor-made contract. It can be for any amount of money and can settle on any date that's not a weekend or holiday.
8/19/ · Monetary policy in forex is a governments policy through the Central banks to control the amount of money in circulation. Its aim it to stablize prices and economic . AdTrade stocks, bonds, options, ETFs, and mutual funds, all in one easy-to-manage account. Trade with confidence. See how Power E*TRADE makes it quick & simple. Start now! Inflation Contractionary monetary policy is used to target a high level of inflation and red Unemployment An expansionary monetary policy decreases unemployment as a higher See more.