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Should a central bank use its currency reserves to support the value of its country's currency in the foreign-exchange market? What can be achieved by such intervention?

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Introduction

SHOULD A CENTRAL BANK USE ITS CURRENCY RESERVES TO SUPPORT THE VALUE OF ITS COUNTRY'S CURRENCY IN THE FOREIGN-EXCHANGE MARKET? WHAT CAN BE ACHIEVED BY SUCH INTERVENTION? INTRODUCTION: For International Business to operate there needs to be a currency exchanged mechanism. The need to exchanged currencies will stem from either investment to meet one's cost or to repatriate the profits that the business has accumulated in foreign countries. Foreign exchange is a commodity that consists of currencies issued by counties other than one's own. Like the prices of other commodities, the price of foreign exchange- given a flexible exchange rate system- is set by demand and supply in the marketplace. A country's central bank has an "official reserves account" where it holds reserves which are used to intervene in the foreign exchange market. These reserves hold different assets, mainly gold and convertible currencies. These convertible currencies are hard currencies, that is currencies that are freely exchangeable in world currency market. A central bank can support its country's currency by selling part of its foreign currency reserves on the exchange markets and buying its domestic currency, therefore increasing the value of the country's currency and "supporting" the value of it in the foreign exchange market. ...read more.

Middle

The speculators would buy a safer currency, for example, the U.S. dollar. In the case of Thailand this proved to be unsustainable for the Thailand central bank and on July 2nd 1997 allowed market forces to devalue the baht by 20%. The bank of Thailand spend almost $10 billion of its foreign-currency reserves defending the fixed value of the baht before throwing. This had many other implications and made Thailand far more competitive in its exports, so much so that its neighboring Asian countries were also forced to devalue, creating effects known as the "Asian Contagion" which effected the rest of the world to different degrees. With the devaluation of baht, Thailand exports suddenly became 20% cheaper, making Indonesia, Malaysia, and Philippine exports relatively more expensive. By early September 1997 the baht had devalued 26% relative to its value against dollar. Thailand stock lost 60% of its dollar value. In the case of Indonesia , Indonesia early was hit on July 1997. Indonesia rupiah devalued 21%, and stock loss 30%. Bank Indonesia floated the rupiah on August 14, 1997. Intervention in both the forward and spot markets were continued. To support the currency intervention, monetary tightening, through monetary and fiscal means, was conducted. ...read more.

Conclusion

This way the rates are determined by supply and demand and Thailand would not have experienced the economic troubles that they did. They spent much of their reserves buying their currency and this represents a huge opportunity cost-their reserves into a bottomless pit and essentially gained nothing as a result. In the long-term fixed exchange rate is economically unfeasible for a central bank to support its currency as it would eventually run out of official currency reserves. In short-term Thailand and Indonesia experienced many of the benefits associated with having a fixed exchange rate and used their currency reserves. Once they started doing this they needed to address the issue of why their currency was weakness and a large trade deficit. CONCLUSION: Central bank choice by itself whether or not support their currency. They may consider whether the country is developing or developed and therefore use different strategies. If currency fluctuations occur in the short-term a central bank can use its currency reserves and remain fixed and enjoy all the benefits that comes with it, but the economic must be similar enough and the country must have a good economic policy to eliminate the need for long-term central bank support. When fixing currencies together it is important that the economics are coherent, which protects the currency from asymmetric shocks, this will ensure success in the long run. ...read more.

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