Central Banks

Monetary Policy

• How a central bank controls money supply and interest rates to influence the economy.

• Raising interest rates strengthens currency; lowering rates weakens it.

• The central bank acts like a “thermostat”; adjusting money flow to keep the economy from overheating (inflation) or freezing (recession).

Interest Rate Adjustment

• Central banks raise or lower interest rates to control borrowing and investment.

• Higher rates attract foreign investors → stronger currency.

• Lower rates make borrowing cheaper → weaker currency.

• Higher interest rates are like offering better “rent” for parking money; more investors want your currency.

Open Market Operations (OMO)

• Buying or selling government bonds to control how much money is circulating

• Selling bonds reduces money supply (strengthens currency);

• buying bonds increases it (weakens currency).

• Like soaking up or releasing water from a sponge; controlling how “wet” (liquid) the economy is.

Foreign Exchange Reserves

• These are foreign currencies and gold held by a central bank to stabilize the national currency.

• The bank can buy its own currency (to support it) or sell it (to weaken it).

• Like keeping a stash of apples and oranges to swap when prices swing; balancing the trade smoothly.

Currency Intervention

• When a central bank buys or sells its own currency in the foreign exchange market to influence its value.

• Buying its currency pushes value up

• Selling it pushes value down.

• Like a referee stepping into the market to stop the game from getting too wild.

Exchange Rate Regimes

• The system a country uses to set its currency’s value

• Fixed (Pegged): Value tied to another currency (e.g., USD).

• Floating: Value set by market forces.

• Managed Float: Mostly market-driven but with government adjustments

• Fixed = Locked steering wheel;

• Floating = free drive

• Managed float = Autopilot with driver override. 

Fiscal Policy

• Government’s use of spending and taxation to influence the economy

• High government spending can cause inflation (weaker currency);

• Balanced budgets help strengthen it.

• Spending more than you earn makes your wallet thinner; the same goes for national currency value.

Trade Policy

• Government rules on imports, exports, and tariffs

• Promoting exports increases demand for local currency

• Heavy import reliance can weaken it.

• Selling your goods abroad makes everyone want your money; buying too much from others drains it away.

Capital Controls

• Rules limiting how much money can enter or leave a country

• Prevents sudden inflows or outflows that cause wild currency swings.

• Like a valve on a pipe that keeps water (money) pressure steady by controlling flow.

Inflation Targeting

• A central bank sets a clear inflation goal (like 2%) and adjusts policies to stay near it.

• Predictable inflation helps keep currency stable and trustworthy

• Like aiming to keep your car at a steady speed, not too fast (inflation), not too slow (deflation).

Economic Diversification

• Developing multiple industries so the economy doesn’t depend on one export (like oil or tourism).

• More balanced exports and income reduce volatility in currency value.

• Like having several legs on a stool; if one weakens, the others keep it stable.

Reserve Requirement

• The percentage of deposits banks must keep in reserve (not loan out)

• Higher reserve = less money circulating (stronger currency)

• lower reserve = more money circulating (weaker currency).

• Like telling kids to save some of their allowance, less spending keeps “prices” stable.

Sovereign Wealth Funds (SWF)

• Government-owned funds that invest extra national income (often from oil or trade surpluses) abroad.

• Help manage exchange rates and stabilize income.

• Like saving extra harvest in a granary to use when crops fail

Confidence & Communication Policies

• Central banks often announce clear goals and future policies to guide investor expectations.

• Predictability strengthens investor trust and keeps markets calm.

• Like a pilot calmly explaining turbulence, people stay seated and don’t panic.

Pegging/Devaluation

• Pegging: Fixing a currency’s value to another (like USD or gold).

• Devaluation: Officially lowering that fixed value to boost exports.

• Pegging keeps stability

• Devaluation makes exports cheaper but imports costlier.

• Pegging is like tying your boat to a big ship

• Devaluation is lowering your anchor to catch more trade winds.