Written Assignment Unit 6

Principles of Finance Written Assignment Unit 6 Central banks play a pivotal role in the future of economic prosperity. The decisions of committees within a central bank impact financial institutions worldwide. So it is essential to have a basic understanding of how central banks work and the effect they could have on one’s life. As we are currently experiencing today’s financial crisis, we can see that targeting money supply and interest rates is often impossible to achieve, as we saw the shutdown of businesses and lockdowns throughout the U.S.A. The FED lowered interest rates to near zero to keep the economy from a deep recession. This meant that there was more money to borrow, and people went out and purchased homes, vehicles, and other goods. Yet only a few months later, the government lifted the lockdowns, and more money was being spent in an economy that was not producing fast enough, which led to higher inflation and rising cost in the basket of goods. To combat the high inflation, the FED has been raising interest rates as fast as it lowered them during the pandemic. The money supply in the United States fluctuates based on the actions of the Federal Reserve and commercial banks. Money supply and interest rates have an inverse relationship. A larger money supply lowers market interest rates, making it less expensive for consumers to borrow. Conversely, smaller money supplies tend to raise market interest rates, making it pricier for consumers to take out a loan. The current liquid money (supply) level coordinates with the total demand for liquid money (demand) to help determine interest rates. The Fed must look at the economy’s overall strength. This includes studying factors like inflation, unemployment, and supply and demand. Once these are determined, the central bank can decide whether to raise or lower rates. So as we can see from what has happened in the last couple of years, it is not as easy as it sounds for central banks to simultaneously simultaneously simultaneously simultaneously hit their target of money supply and interest rates. Another way a central bank can try to manipulate the money supply in the economy is by intervening in foreign exchange markets. Here, the term intervening means that central banks either buy or sell their currency on the foreign exchange markets to raise or lower the value against other currencies. Central banks will typically do this when the nation’s currency is experiencing excessive upward or downward pressure from investors in the market. Intervention from central banks in the foreign exchange market affects the price of imported and exported goods and inflation. This will then force the central bank to either raise or lower interest rates to keep inflation at its target range. The main reason for a central bank to intervene in the exchange rate is for the local economy to benefit over that of the global economy. There are several critical factors in the determinants of an exchange rate in the long run. The first would be the interest rate; as we have seen recently, the US Dollar is in high demand because the FED raised the interest rates. This is so because demand for that currency increases when interest rates are high in the domestic country, demand for that currency increases. The next factor would be the inflation rate of the home country. The higher the inflation rate, the less purchasing power that currency has. This can be seen as the opposite of when inflation is low; it means the home currency would have more purchasing power. Another factor is the risk that is associated with the home country. Uncertainties and volatility in the nation would make the exchange riskier to other countries, making it lose value. As opposed to a more stable government,e you can find their currency value to fluctuate dramatically. The prices of goods and services can change in the market and influence the exchange rate in the long run. So we can say that the law of demand and supply also has a say in what kind of value is placed on the foreign exchange market. As we can see, the foreign exchange market can react in the short run due to central bank policies and attempt to adjust the economy. In the long run, the market outcome is determined by how all the factors of the economy tie together. The central bank might know what direction to take the economy, but it does not always work out.