Central banks can take steps to strengthen or weaken their currencies
Central bank intervention in foreign exchange markets has come to the fore during the global financial crisis and the recovery. Intervention typically involves a central bank buying and selling another country’s currency and trading its own. When selling currency, a central bank may try to stop its currency rising in value – which in turn can stimulate demand for exports and increase growth. In past months, central banks in several countries have been intervening in foreign exchange markets.
Perhaps most notably, the Bank of Japan weakened the yen after it had risen strongly against the US dollar over the past year.
This week, International Monetary Fund (IMF) managing director Dominique Strauss-Kahn warned countries against using currencies as a “policy weapon”, in an interview with the Financial Times noted by The Economist magazine.
The potential dangers of intervention
Foreign exchange intervention by central banks involves risks. Persistent intervention may keep a currency weaker than it would otherwise be and lead to claims that a country is trading unfairly. In the worst case, other countries may respond by allowing their central banks to intervene and weaken their own currencies, leading to what is known as “competitive devaluations”.
Trade tariffs or other taxes on imports are another possible response.