Financial Markets and Institutions (2-downloads)

exchange interventions to influence exchange rates. In our current international

environment, exchange rates fluctuate from day to day, but central banks attempt

to influence their countries’ exchange rates by buying and selling currencies. We can

use the exchange rate analysis we developed in Chapter 15 to explain the effect

of central bank intervention on the foreign exchange market.

Foreign Exchange Intervention and 

the Money Supply

The first step in understanding how central bank intervention in the foreign exchange

market affects exchange rates is to see the effect on the monetary base from a cen-

tral bank sale in the foreign exchange market of some of its holdings of assets denom-

inated in a foreign currency (called international reserves). Suppose that the

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Fed decides to sell $1 billion of its foreign assets in exchange for $1 billion of U.S.

currency. (This transaction is conducted at the foreign exchange desk at the Federal

Reserve Bank of New York—see the Inside the Fed box.) The Fed’s purchase of dol-

lars has two effects. First, it reduces the Fed’s holding of international reserves by 

$1 billion. Second, because the Fed’s purchase of currency removes it from the hands

of the public, currency in circulation falls by $1 billion. We can see this in the following

T-account for the Federal Reserve:

Chapter 16 The International Financial System