What roles do Central Banks play in the currency markets?

130313135158 central banks currency 1024x576 1
130313135158 central banks currency 1024x576 1

what roles do central banks play in the currency markets?

What roles do Central Banks play in the currency markets?


Miguel Ángel Fernández Ordóñez, Spain’s former central bank chief was charged for enabling the Spanish people to buy shares in a new bank that he knew was guaranteed to fail. After it failed he would exercise his powers in the central bank to bailout the bank making him and the central bank a fortune twice over. Along with 65 other elite bankers who committed a string of financial crimes it is a massive effort by Spain to get rid of corruption within the banking system.

This is somewhat of a world first as Central Banks generally classified as above the law and independent. The independence of the central bank is enshrined in law. This type of independence is limited in a democratic state; in almost all cases the central bank is accountable at some level to government officials, either through a government minister or directly to a legislature. Even defining degrees of legal independence has proven to be a challenge since legislation typically provides only a framework within which the government and the central bank work out their relationship.


So what does a central bank do to warrant such power? A central bank, reserve bank, or monetary authority is an institution that manages a state's currency, money supply, and interest rates. Central banks also usually oversee the commercial banking system of their respective countries. In contrast to a commercial bank, a central bank possesses a monopoly on increasing the monetary base in the state, and usually also prints the national currency.

The Reserve bank of Australia (RBA) holds the role of Australia’s central bank and thus it conducts monetary policy, works to maintain a strong financial system and issues the nation's currency. It also manages Australia's gold and foreign exchange reserves. The bank aims to provide stability of the currency of Australia; maintain full employment and ensure the economic prosperity and welfare of the people of Australia.


It achieves these through goals through what’s called monetary policy or changing the official interest rates. Interest rates are the rate in which banks charge to borrow money. The theory behind the policy is that if rates are low then more people would borrow as it costs less in interest payments, as a result more people are buying and spending and in turn there is generally more economic activity. A situation when the RBA lowers interest rates, is called lose monetary policy as the ‘purse strings’ have been loosened. On the other hand tightening monetary policy is a situation where the RBA increases interest rates thus its more expensive to borrow money, there is less money in the market and economic activity slows. When the economy is overheating or too inflated the Reserve bank will maintain stability by tightening the strings.


There is generally a 9-12 month lag affect from when an interest rate decision is made and the economy starts to change in accordance. However it has an instant affect on a nations currency price. For example if the RBA came out and raised interest rates, the Australian dollar generally increases instantly in price. Similarly if the RBA decreases interest rates then generally the Australian dollar instantly falls. Knowing this gives a trader a distinct advantage in the lead up to an interest rate decision. If it is looking likely that the RBA will change rates then a trader can place a trade and if the direction is correct then the trader will profit. This opportunity comes around every month in Australia on the first Tuesday of the month.


The RBA in majorly concerned with three factors when considering an interest rate change Inflation, employment and currency stability. Australia has an inflation target of 2-4% meaning prices of all goods in the Australian economy should rise from 2-4% each year, they believe this encourages spending and investment as people are forced to buy now rather than later. It also discourages savings as money in the bank loses 2-4% of its value every year so people are encouraged to invest the money in order to beat the inflation rate. If Australia’s inflation rate is below 2% then the RBA may raise the interest rate to stimulate the economy and vice versa if the inflation rate is too high it may look to raise rates to dampen demand.

A somewhat controversial goal of the RBA is to achieve full employment. Again if unemployment is too high the RBA will look to lower interest rates to spark investment in employment. This policy has been debated heavily as monetary policy can be seen as an inefficient way of dealing with employment. A nation can be in a situation of stagflation which is when there is high inflation combined with high unemployment, a central bank has its hands tied as lowering the interest rate to spur employment would inevitably further raise inflation at the same time. There for when the Australian Bureau of statistics release the employment numbers or how many jobs have been created in the economy over the last month, the finance world looks on with much interest as this will have a major affect on the following interest rate decision.

On the first Friday of every month the United States release what is called the ‘Non-Farm Payrolls’. Basically every job created in America over the last month, that’s not farm related. This is seen to be the largest trading day of every month as it has a major affect on the US Dollar. If the numbers are good and more jobs have been created than expected then the dollar generally rises as the chances of a future interest rate hike increases.

The third factor is currency stability, we have seen recent examples here in Australia of the RBA seeing the Australian dollar too high and raising rates to bring the dollar back to a level, which suits our economic activity. The Reserve Banks governor Glen Stevens can also achieve this just by talking about the idea of raising interest rates, which is known as ‘jawboning’ the dollar. A high dollar is great for Australian importers but it has a detrimental impact on Australian exporters as people in other countries pay more for Australian goods. On 12 December 1983 the Australian government ‘floated’ the Aussie Dollar meaning through natural supply and demand the dollar generally corrects itself, however the RBA uses these intervention techniques to artificially create a price they think is fit.

There are many factors that drives the Australian dollar up and down and to keep abreast of its movements and how it reacts to certain geopolitical circumstances can be a very exciting. As the dollar moves there are opportunities to make great amounts of money through currency trading. Learning how to read economic news properly can help you achieve success in the money markets.

If you are interested to learn more about this then contact myFXplan today on +613 8393 1800 or visit www.myfxplan.com

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