Intervention and Trading – Methods that Move the Forex Market –New

One may often wonder what the forces that affect the fluctuations of the currencies in the foreign exchange market are. In an enterprise such as this free floating exchange rate system, supply and demand forces are very meaningful forces on the exchange rates. However, other outside factors are also affecting the market deliberately. One of these factors is the intervention of outside groups such as the central banks that work towards raising or lowering the exchange rate in the floating market.

It is harder to make international trading and investment decisions if the exchange rate is constantly moving. In order to give more security to traders by stabilizing or minimizing fluctuations in exchange rates, pressure is often placed on the government or the central bank to intervene so that traders will not reduce their investment activities because of the constant fluctuations.

Other times, when a country’s currency is going down, the central bank can intervene to stop or reverse the country’s trade deficit. By doing this, the whole country’s economy can be changed for the better, since a higher exchange rate brings the countries various goods and services at a cheaper rate. This move can also reduce the trade deficit on exports if the deficit is significant enough for the government to intervene.

The central bank may intervene through different approaches. One of them is a direct method in which the central bank buys or sells currency in an attempt to influence the market in the desirable direction. By flooding the market with a certain currency, the raise in its supply will bring its value to be reduced, whether if the central bank purchases large amounts of a certain currency it herein increases its value. Of course that his does not have a long term effect on the market, but can be effective for a short period until the market stabilizes again and the former trends are reintegrated.

Another approach is the indirect method of intervention, in which the central bank attempts to alter the current exchange rates by shifting the domestic money supply. Through this method, by increasing the supply of money the value for that currency will decrease. Similarly if the money supply is decreased the value for it will increase. However, this method of intervention is a bit more complicated since the central bank also needs to alter the domestic interest rates to compensate for the change in money supply, and although it is effective, this method must traverse all market operations before affecting the exchange rate, a process that slows the impact of the intervention often to several weeks.

Government or central banks intervention are not applied very often in spite of their benefits because of the long term effects that can damage domestic favors. Changing the money supply can affect interest rates and price levels, leading to higher inflation rate, higher unemployment rates, and less gross domestic product growth in the long run. For this reason, there are other interventions used to stabilize the market without too many long term effects.

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