The Role of Central Banks in the Forex Market

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Role of Central Banks in the Forex Market

The forex market is famous as the arena on which many players participate. One of the largest of them is central banks. Their importance is stressed by the fact that they can to a certain degree influence the price fluctuations of the traded currencies. Despite this, central banks should not be regarded as speculators.

They can enter the forex primarily for two reasons. First of all, they may start trading for the purpose of supervising the currencies market. Secondly, their goal may be to control the supply of currencies and the corresponding interest rates.

Generally, from time to time when need requires, governments and central banks may interfere in the foreign exchange market in order to adjust fluctuations in correspondence to the economic goals they have to follow. In order to combat potentially high inflation rates, the central bank of a country may interfere so that it regulates the supply of money. This is usually done through a change in interest rates.

Since inflation leads to devaluation of money, central banks tend to adjust interest rates in order to decrease the amount of money that chases goods and services.

Since markets tend to be volatile, when this volatility gets out of control, central banks may interfere. Reasons also include:

  • Stability restoration
  • Protection of a particular price level
  • Reduce the speed of the movement of a currency
  • When a trend needs a change in direction

The central bank is not required to announce its operations. Additionally, the desired operations can be done through the use of the services of different agents or brokers.

The strategy that the central bank will follow depends on the needs of the situation and the goals it wants to achieve. If the stability on the market is hurt, then different central banks may collaborate to fix the problem.

On the other hand, countries that regard government intervention as an undesired strategy may resort to it only in extreme cases (e.g. nature disasters or political turmoil). In the case of capital flows, trade patterns or interest rate differentials, governments and central banks will be more reluctant to interfere, since these represent typical of the forex factors.

If the price levels get out of control in either direction, central banks may find it necessary to intervene. On several occasions the US government has embarked on the selling of dollars so that decrease its value. The reverse was also done, if the dollar was considered to be too weak as compared to economic fundamentals.

However, such interventions don’t have a big impact on the general activity of the forex market thanks to its high volume. Additionally, they are not immediately reflected on the supply and demand balance. Such interventions are used as a signal pointing to the desired level of rate. Furthermore, they tend to influence the trading behavior of market participants.

Economic activity was greatly influenced by the introduction and establishment of the Eurocurrency market. It involves the holding of foreign currency in a domestic bank. Such deposits represent a big portion of the forex market transactions. As a result of these reserves of central banks, the transference of such deposits from one country to another may have an implicit effect on the forex market.