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Currency Intervention (Chain of Analysis)

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Last updated 14 Jan 2019

Here is an example of a chain of analysis on the question "How can a central bank influence the value of a currency?"

Currency Intervention (Chain of Analysis)

In a managed floating currency system, one way that a central bank can influence the external value is by changing interest rates. For example, if they want to achieve a depreciation, they might opt to lower their main monetary policy interest rate. A fall in interest rates reduces the returns on overseas money held in a country’s banking system. The real return may become negative. As a result, lower interest rates might cause an outflow of short-term “hot money” from commercial banks to other countries. This will cause an outward shift of the supply curve for the currency as investors look for currencies with higher expected returns. In this way, assuming other central banks have kept their rates constant, a fall in interest rates might lead to a depreciation.

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