In a recent speech, European Central Bank (ECB) President Mario Draghi indicated

Question

In a recent speech, European Central Bank (ECB) President Mario Draghi indicated that the central bank is concerned that the appreciating currency could undermine the regional’s fragile recovery. The Wall Street Journal on March 14 summarizes the situation as follows:

“The top euro zone central banker added a powerful voice to increasing concerns among policy makers across the region that the strength of the euro is affecting inflation, which for months has been well below the central bank’s target of just under 2%. That could prompt the ECB to potentially implement measures designed to weaken the common currency.”

President Draghi further added:

“That is why the ECB has been preparing additional nonstandard monetary policy measures to guard against [deflation] and why it stands ready to take further decisive action if needed.”

Answer the following questions:

(a). How can a central bank intervene to affect the exchange rate of the local currency? Show both direct intervention and indirect intervention (through monetary policy) in a diagram of the exchange rate market.

(b). Carefully explain and show in an AS-AD diagram how these measures of direct and indirect intervention (resulting in a weaker currency) can lift deflationary pressure (i.e., increase the price level). Which components of AS and/or AD does the central bank’s intervention affect? Discuss direct and indirect intervention separately.

(c). What is the effect of such a policy on unemployment? Explain.

Explanation / Answer

(a) Central banks can intervene to affect the exchange rate of the local currency. It occurs when a government buys or sells foreign currency to push the exchange rate of its own currency away from equilibrium value or to prevent the exchange rate from moving toward its equilibrium value. Often, Central banks intervene in foreign exchange markets in order to achieve a variety of overall economic objectives like, controlling inflation, maintaining competitiveness, or maintaining financial stability.Direct currency intervention is generally defined as foreign exchange transactions that are conducted by the monetary authority and aimed at influencing exchange rate. Indirect currency intervention is a policy that influences the exchange rate indirectly. Some examples are capital controls (taxes or restrictions on international transactions in assets), and exchange controls (the restriction of trade in currencies).

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