How does monetary policy affect the forex market

Monetary policy is  a policy used by governments through the central banks to control the amount of money in circulation for price stability and economic development. The central banks operate under the rules of the government to regulate money circulation with a goal of achieving economic stability and development.

There are two ways in which the government can execute its policy.

  1. Expansionary monetary policy
  2. Contractionary or restrictive monetary policy

The main aim of the government is to;

  • Control inflation
  • Regulate the money supply
  • Regulate interest rates of commercial banks
  • Improve economic development
  • Trade balances

How does monetary policy work?

 The government uses the expansionary monetary policy through the central bank when it wants to increase the amount of money in circulation or increasing money supply. The central bank cuts interest rates making borrowing cheap which encourages spending hence improving peoples standards of living and economic development.

Money supply can also be increased through the following ways.

  • Reducing on the reserves required by the central banks from commercial banks which increases the amount of money available in banks for borrowing.
  • The open market operations where by the central bank will encourage its citizens to sell their securities like bonds treasury bills to the government for cash at a profitable amount.

As more money gets into circulation, it speeds up economic development and standards of living of people leading to high demand for goods and services.

As people get more money they spend more. It weakens the domestic currency making it expensive to spend on foreign goods. As a result, people will spend more on domestic products leading to further increase in prices.

It’s the persistent increase in prices that slows down the economy because people buy less with much money so the currency value eventually falls.  Inflation leads to high prices, high costs of production, demand for increased wages leading to unemployment hence poor standards of living.

When this happens, the government intervenes to save the economy by using the Contractionary or Restrictive monetary policy.

This is how it does it;

  1. Increasing  interest rates to discourage borrowing to spend. It  also attracts foreign investors interested in the high yield returns to invest and encourages saving in the bank hence reducing on the disposable money for spending.
  2. Money supply can also be regulated by increasing bank reserves and encouraging the public to invest in government securities.

Whatever the case it may be, central banks are always there to help you by regulating these situations and making sure they maintain the economic balance. So it is important to always know when such important data is to be released so that you are able to adjust to certain changes in the market.

Hawkish vs Dovish Central banks

 Those two sound like birds names, hawks and doves; Interestin’!

This means raising interest rates or lowering them. The two terms describe opinioins taken  by Central Banks on the issue of interest rates.

The Central Bank can be termed as hawkish or dovish depending on the approach used while determining the interest rate

A dovish Central Bank cuts interest rates to encourage the public to borrow for expenditure while making spending very cheap.

Hawkish, when the monetary policy is to raise the interest rate to curb down inflation and improve the economic growth.

How does Monetary policy affect the forex market.

When the Central Bank uses its monetary tools like cutting interest rates to boost domestic expenditure, it increases amount of money in circulation making the currency cheap abroad hence a fall in its value. This forces foreign investors to sell off the currency looking for higher yielding currencies. The expansion monetary policy makes the forex market more bearish due to expected fall in value of the currency in question.

When the Central Bank decides to raise interest rates or to use a contraction monetary tool on the economy, it aims at reducing the amount of money in circulation to curb down inflation. When this happens, currency gains value and more investors rush to invest in a higher yielding currency making the forex market more bullish. This is because hiking of interest rates is a sign of  good economic growth in the country in question.


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