Central Bank FX Interventions

One of the things economists understand is that you cannot really have everything. Take, for example, the impossible trinity. Basically, it suggests that countries are faced with three options: an independent monetary policy, a fixed exchange rate, and free movement of capital. While authorities can have two out of three, they cannot really have them all. Hence, most developed countries opt for monetary policy independence and free movement of capital at the expense of a floating exchange rate.* As a result, capital moves around the world fast.

Remember that an influx of capital has important effects on the exchange rate: a higher influx of foreign currency in Europe means that people are willing to exchange their own currencies for the Euro. In economic terms, demand for the Euro increases which is usually translated as an increase in price, i.e. the exchange rate. The issue with this is that, depending on the extent of the Euro appreciation, it may actually hurt European exports given that they will now be more expensive compared to other countries’. If, for some reason, the exchange rate appreciation gets exceedingly large, then this inflow of capital can actually hurt the economy, especially one which is export-oriented.

Take Switzerland for example: its economy is heavily dependent on exports with a trade surplus (i.e. exports being higher than imports) recorded in every year since 2002 (see figure below). Despite the fact that Swiss exports mainly consist of higher-end goods, which tend to be more price inelastic, there still exists at least some of a reaction to a CHF appreciation. As such, the Central Bank can assess that it is to the economy’s best interest not to allow the exchange to rise.