The exchange rate as a monetary policy instrument – FAQs
- What was the aim of using the exchange rate as a monetary policy instrument? Why did the CNB start to use foreign exchange interventions?
- When did the CNB start using foreign exchange interventions, and why did the CNB decide to achieve its monetary policy objective using the exchange rate?
- What is the effect of exchange rate depreciation on the Czech economy and on businesses and households?
The aim of using the exchange rate as an additional monetary policy instrument – and therefore of using foreign exchange interventions to weaken the koruna – was the same as in the case of interest rates. In line with the CNB’s statutory mandate, the objective was to maintain price stability in the Czech economy, which is expressed by the CNB’s inflation target of 2%. In other words, the aim was to prevent deflation, to ensure that the 2% inflation target was achieved in a sustainable manner and to accelerate the return to a situation where the CNB would again be able to use its standard tool, i.e. interest rates. The use of foreign exchange interventions as an appropriate tool for countering deflation risks had been recommended by an IMF mission in 2013. In terms of the CNB’s secondary objective, i.e. supporting the general economic policies of the government leading to sustainable economic growth, our action helped overcome the longest economic recession in the history of the independent Czech Republic, a continuation of which was not in the interests of most companies or the public.
The CNB Bank Board decided to use the exchange rate as a monetary policy instrument, and therefore to commence foreign exchange interventions, on 7 November 2013. For the Czech Republic, as a small open economy with a long-term excess of liquidity in its banking sector, this was a more effective instrument for easing the monetary conditions than any other. The decision to use the koruna exchange rate as a potential additional tool for monetary policy easing after the lower bound on interest rates was reached was made by the Bank Board in autumn 2012.
A weakening of the exchange rate of the koruna leads to an increase in import prices and thus also in the domestic price level. To a lesser extent, it also boosts domestic economic activity. The rise in import prices can be expected to reduce households’ purchasing power, but households’ demand may be redirected towards domestic goods and services to a greater extent and additionally supported by lower real interest rates as a result of higher inflation expectations. At the same time, the weaker exchange rate supports Czech exports and the profitability of corporations and their willingness to invest. The recovery in production then contributes to a rise in employment and wages, which increases the purchasing power of households.