Describe two channels through which foreign exchange interventions may affect the value of the exchange rate

Question

What will be an ideal response?

Answer 1

There is a direct and an indirect channel. As indicated in question 7, the direct effect of forex purchases or sales is likely small, because trading volumes are so large in the forex market, but there may be some short-term effects if the inventories of dealer banks are adversely affected by the intervention. If not sterilized, interventions affect the money supply, but that effect too, is likely to be small relative to the size of the money supply. The indirect channel refers to the fact that an intervention can alter peoples' expectations and affect their investments, thus helping to push the exchange rate in the direction the central bank desires. For example, the intervention may be a signal to the public of the central bank's monetary policy intentions, or it may signal the central banks inside information about future market fundamentals, or it may signal to investors that a currency's exchange rate is deviating too far from its long-run equilibrium value. The signal is costly and therefore potentially more credible, because if the central bank is wrong and, for example, buys an "undervalued" currency, which keeps depreciating, the intervention will lose money.