Overview

With the constant drama in the financial markets concerning the extensive deliberation of the US central bank, the Federal Reserve, as to the raising of interest rates, government policy and its effect on currency has been in the limelight recently.

Economists and traders alike have been conjunct in debating what a Fed rate hike would do to both the forex markets and the share markets, and whether, indeed, the Fed should even raise rates or not. Some say that there is no reason for the Fed to raise rates, with the US economy keeping a very low inflation rate as of late.

However, others ponder whether it is the right time for “lift off”, given that they feel the economy is strong enough to handle an incremental increase in interest rates, which would be the catalyst for the slow but steady process of economic normalization. Within the confines of this article, a much broader approach will be taken with regards to the effect of government policy on currency. There are two types of government policy, which are fiscal policy, which relates to government spending, and monetary policy, which relates to the supply of currency within a country.

Government Policy And Currency

Indeed, the first aspect to scrutinize when it comes to government policy is the monetary aspect, namely, the raising and lowering of interest rates. This is done by the central has, however, the government have an enormous role in it. Quite simply, a raise in interest rates will increase the overall cost of borrowing money, which means that, in the long run, due to human psychology, a lesser proportion of previous borrowers will borrow money. As less borrowing is occurring, the total amount of investment in goods and services is reduced.

By looking throughout history, we can see that the aforementioned reduced amount of investment in goods and services is contemporaneous with a decrease in inflation. Traditionally, the interest rates of a country act as a barometer for the health of an economy, with high interest rates being synonymous with a strong economy. This restrictive monetary policy will increase the value of a currency, as investors will get a higher rate of return for keeping their money with specific banks. Of course, the opposite of restrictive monetary policy is accommodative monetary policy, which will, simply, do the exact reverse of what the restrictive policies did, with the value of currency decreasing as this monetary policy will increase the inflation rate.

We move on now to fiscal policy, which has everything to do with how the government wishes to spend their money. If a government wishes to pursue an expansionary fiscal policy, they would cut taxes and increase government spending. A prerequisite of this, in the very likely case that a government does not have enough reserves to handle all of this by themselves, is that borrowing will have to be increased, thereby worsening the budget deficit of a country, simply the difference between the amount of money taken in by a country and the amount which they spend.

As this loose fiscal policy might have a positive effect on investment inflows into an economy, the value of the currency of that country will therefore appreciate, through the money being injected into the economy. However, some governments wish to persist with a tight, or deflationary, fiscal policy, which, simply, involves doing the exact opposite of loose monetary policy, with an increase in taxes accompanied by a decrease in government spending. This would decrease the amount of investment into an economy, thereby making the value of that currency depreciate.

When one is asked about government policy with relation to the economy, they would immediately think of banks. This instinctive reaction is, funnily, not too far from the truth, with changes in the reserve requirement for banks having a substantial affect on the value of currency within that country. If the reserve requirement of a bank is increased, it means that the amount of money which the bank can lend out is decreased, as they have to save a greater proportion of their capital.

This means that the bank would want to raise their interest rates, which is obviously good for people putting their money into banks, as they get a higher yield from their investment. The bank having high-interest rates will attract investors from abroad, increasing the value of the currency due to higher capital inflows into the banks.

A lowering of reserve requirements will have the opposite effect on currency, with banks lowering their interest rates as they can lend out more money. Among others, an amalgamation of these factors makes the value of currency change every day, and, in truth, no one can predict what a government will do, which is the reason for the heavy volatility that occasionally occurs within forex markets.

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