The impact of policy on a currency

Before reading this article, you should have previously read through:

This lesson will show you how government and central bank policies can have a direct impact on the value of a currency through monetary and fiscal policy.

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The impact of policy on a currency

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Money supply is the total amount of money available in the economy

The value of a currency, just like any other financial asset, is determined by supply and demand. The actual supply of money within an economy therefore impacts the value of a currency. Money supply is defined as the total amount of money that is available within an economy. If the money supply increases, there is more for investment and spending and this has a stimulus effect on the economy – the opposite effect is seen if the supply is reduced.

Money supply is the total amount of money available within an economy. Too much money supply and inflation starts to rise; too little money supply will stunt growth.

It is important to maintain control over the growth of the money supply. Too much supply and the rate of inflation can rise to levels that can harm the economy – too little can stunt economic growth. Policy makers have to strike the right balance between growth and inflation – they will do this through either restrictive or accommodative monetary policy.

Restrictive monetary policy is when a central bank will look to reduce the money supply and accommodative monetary policy is when a central bank will look to increase the money supply.

Two common ways in controlling the money supply is through either setting interest rates or changing a bank's minimum reserve requirement.

Changing the interest rate affects the money supply

Restrictive and accommodative policy

In order to restrict the amount of capital in an economy, a central bank may raise interest rates. This effectively restricts the amount of borrowing that a consumer or a business is able to do, because higher interest rates means higher borrowing costs. Reducing the amount of borrowing in an economy reduces the amount of spending and investment and therefore lowers the demand for goods and services. Inflation is likely to be brought under control, because under less demand for goods and services, prices are likely to increase at a slower rate, or in some instances fall.

Raising interest rates makes borrowing more expensive and lowers the amount of capital within the economy for investment and spending

In order to increase the amount of capital available in an economy, a central bank will look to lower interest rates in order to make borrowing cheaper and the economy is therefore stimulated under increased borrowing and spending.

Restrictive policy has a positive effect on a currency

Restrictive monetary policy is likely to have a positive effect on a currency because raising interest rates will attract new capital into an economy. This is because high interest rates are usually indicative of a strong economy and investors get a higher rate of return for the capital they hold in banks within that economy.

Accommodative monetary policy has a negative effect on a currency

Lowering interest rates makes borrowing cheaper and increases the amount of capital within the economy for investment and spending

Accommodative policy is likely to have the opposite effect on a currency because making capital more readily available is likely to produce inflationary effects. This reduces the spending power of a currency within the economy making it less valuable. Lower interest rates will also mean that investors get a lower rate of return for the capital they hold in an economy. Investors will seek to invest their capital elsewhere, which contributes to the decrease in value of a currency.

To learn more in depth the impact of interest rates on the value of a currency, you can go to the following lesson:

Lesson
Learn about the economic indicators you can use to determine the strength of an economy, and how this impacts currency value.
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Controlling the reserve requirements of a bank affects the money supply

Reserve requirement

Another way of controlling the supply of money is to restrict the amount of money that a bank can use to lend to consumers and businesses. This is done by setting the minimum reserve requirement of a bank.

Banks only have a small proportion of their total assets in cash that can be immediately withdrawn at any one time. The rest of their capital, which is usually most of the capital a bank has, is invested or lent out in the form of loans or mortgages.

Reserve requirement increase

The central bank determines the minimum amount required to hold for immediate withdrawal – this is called the reserve requirement.

Raising the capital reserve of a bank will lower the amount that banks have to loan out – this effectively reduces the money supply. Lowering the capital reserve has the opposite effect and increases the money supply.

If a central bank raises the reserve requirement, then this decreases the amount that banks have to lend out and effectively reduces the amount of capital within an economy, lowering the money supply.

Lowering the reserve requirement therefore has the opposite effect, as banks are able to lend and invest more and this increases the money supply in the economy.

Changing the reserve requirement can impact the value of a currency

This has the same effects on the economy as the central bank changing the interest rate.

interest rates increase with higher reserve requirment

If a bank is required to keep more capital as reserve – restricting the amount they can lend out – then they may end up charging more interest to borrowers. However, operating at higher rates benefits savers because they will get a higher rate of return on their savings.

This is likely to increase the value of the currency, because more capital is likely to flow into that economy to benefit from the higher interest rates. Similarly, lowering the reserve will likely have a negative impact on a currency, because banks can afford to lend out more, and therefore at lower interest rates.

Fiscal policy can be used to stimulate the economy

Government gives money to economy

Government spending is referred to as fiscal policy. Policy makers use them to exert influence over the economy by manipulating taxes and spending.

The money that a government spends is either raised through taxes or through borrowing by issuing debt securities, called government bonds. If a country spends more money than it earns by borrowing from private investors, then this is what is called a budget deficit.

Government spending is referred to as fiscal policy. It is usually a prominent way of stimulating the economy and can be a potent tool when looking to deal with a recession. If a country has a loose fiscal policy, this can cause the value of the currency to rise.

Government spending is usually a prominent way of stimulating the economy and can either be directed at specific projects, such as building and developing infrastructure, or by hiring government employees.

Government spending can be a potent tool when looking to deal with a recession, because the money that has been injected into the economy has a stimulus effect. For example, a project to build government housing will benefit building companies and manufacturers of housing materials.

If a country adapts a loose fiscal policy, this can have a positive effect on the amount of investment that comes into the currency and so the value of the currency is likely to increase in value.

Summary

So far you have learned...

  • ... the money supply – that is the total amount of money within an economy – affects the value of its currency.
  • ... it is important to maintain control of the money supply in an economy: Too much money supply can result in inflation and too little can stunt an economy' growth.
  • ... monetary policy is used to control the money supply.
  • ... restrictive monetary policy is reducing the money supply by limiting the amount of capital available, usually by raising interest rates or raising the minimum reserve requirement that a bank has to hold.
  • ... restrictive monetary policy usually results in an increased strength of a currency.
  • ... accommodative monetary policy is expanding the money supply by increasing the amount of capital available, usually by lowering the interest rates or lowering the amount of capital a bank has to hold in reserves.
  • ... accommodative policy usually results in a decrease in strength in the currency.
  • ... fiscal policy is a way of impacting the economy by government spending.
  • ... fiscal policy can be used to stimulate the economy and usually has a positive effect on the value of a currency.

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