Central Bank Activities and Interventions in the Foreign Exchange Market
The movements on the forex market are influenced by the discount rates and monetary operations of the US Federal Reserve System (also known as FRS) and the central banks of the other countries.
Repurchase agreements have the highest influence on the forex. These represent the agreement to sell the same security back at a date in the future that is determined when the agreement is signed and at the price at which the security was purchased.
The rate of interest is also specified in the agreement. The result of repurchase agreements is the additional injection of a temporary character of funds in the banking system.
This leads to a decrease in the value of the national currency on the foreign exchange market of the country that executes such an agreement. There are two types of repurchase agreements:
- customer repos
- system repos
Matched sale-purchase agreements represent the opposite process explained under the conditions of a repurchase agreement. Namely, the central bank of a country sells a security to a dealer or the central bank of another country.
It agrees to buy it back at a specific date in the future at the pre-determined in the agreement price. The result of the agreement is a drain of reserves of a temporary character. This leads to an increase in the value of the national currency on the forex market.
Central banks may also apply foreign exchange interventions. They are as follows:
- Naked intervention (also known as Unsterilized intervention)This type of intervention represents the foreign exchange activity executed by the central bank. It includes the sole buying or selling of US dollars by the Federal Reserve against other foreign currency.
In this way the movements on the forex market are influenced. Additionally, naked interventions have an impact on the money supply.
This results in a long-term effect on the overall economy, since the changes in money supply lead to the need of adjustments in interest rates, prices and other levels of the country’s economy.
- Sterilized interventionThis type of intervention applied by central banks leads to neutralization of the influence on the money supply. In order to avoid the spillover effect of an intervention activity on the whole economy, most central banks choose sterilized intervention to prevent this from happening.
The Federal Reserve System also uses this tool. A further step toward initial currency transition is undertaken, which includes the sale of government securities. This sale results in the offsetting of the reserve addition that is caused by the intervention activities.
To better understand it, imagine that the central bank uses the sale of several government securities for the purpose of financing the sale of a currency. The sterilized intervention has a short-to medium-term effect, because it influences the supply and demand of a particular currency.