When there is growth in a country there is the chance of inflation. When there is inflation the cost of goods in the country will increase. There are a number of strategies that are used to decrease the inflation in a country. This is due to the effect that the inflation has on the foreign exchange rates. It is important that you know what these techniques are for the foreign exchange rates.
The Foreign Exchange Rates and Interest Rates
Increasing the rates of interest is the method preferred by most central banks when inflation rises. This is a simple, easy method that often yields faster results than other methods. The process is simple as the central bank simply raises the benchmark that retail and commercial banks have to refer to when they offer loans to their clients. The products that are immediately affected by this increase include mortgages, car loans, student loans, personal loans, as well as corporate loans. As soon as the rates increase, money becomes expensive, and this affects both corporations and individuals negatively.
Investors are always on the lookout for high rates of returns, with low risk factors. The same applies to forex investors. When the decision to increase the interest rate is agreed in a country, the demand for that particular currency will experience an increase.
An example of this phenomenon is when the Australian central bank raised its interest rates a few times between 2009 and 2011. By the beginning of 2011, the Aussie dollar had risen by 26% in comparison to the US dollar. When the country’s economy was affected by the global recession, the central bank had no choice but to continue raising the rates to fight the rampant inflation. This decision led to increased demand for the Australian dollar, particularly in comparison to the US dollar.
The Bank Reserves
Another effective strategy that is used is when central banks raise the banking institutions’ reserve requirements. When central banks undertake this method, it limits the monetary base. By increasing the reserve requirement, the central bank is in effect increasing the minimum cash reserve that banking institutions are allowed to hold. This stops the banking institution from lending out the cash they have on hand. The restriction that is placed on money slows down price increases as there is less money available to buy the goods that have become extremely expensive. This is done in the hope of suppressing demand.
This method will eventually curb the inflation of the country’s forex exchange rates. This decision often helps to push the forex rate upward because of the speculators which mean that it plays into the hands of forex investors.
By adjusting the reserve requirement, the country’s central bank is actively acknowledging that they are affected by the inflation rate and are trying to suppress it. This often leads to an increase in attraction for forex investors as they assume that there will be another round of reserve adjustments in the offing. Once the money supply slows down as a result of the banks having to hold higher reserves, speculation will aid in a higher valuation of the country’s currency and this results in the lowering of inflation.
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