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...

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. How can a central bank intervene to affect the exchange rate of the local currency?

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pnrjulius eNotes educator| Certified Educator

The direct action the central bank can take is to purchase foreign money (perhaps dollars or pounds) using newly-created Euros. This will effectively increase the demand for foreign currency, raising the price of foreign currency relative to Euros, meaning that the Euro will depreciate. This is the direct intervention effect.

Now, provided that the central bank doesn't sterilize the intervention by selling bonds to pull currency out of the local market---which it would be a bad idea to do, sterilized currency intervention generally doesn't work---this will increase the money supply of Euros (as some of those Euros will come back to buy European products), raising prices in Euros and then causing further depreciation, the indirect intervention effect.

These two effects are sketched in the first part of the diagram I've attached.

Then we go to the aggregate supply/aggregate demand graph to see what happens within the European economy. The direct intervention does nothing to the local aggregate demand (because all those extra Euros were spent on foreign currency), so there is no point in making a separate line on the graph. The indirect intervention does have an effect however; it raises prices, pulling aggregate demand upward. Prices will rise, output will rise, and with any luck, the rise in output will come with a fall in unemployment. This is shown on the second part of the attached image.

Depending on where we are on the aggregate supply curve, the amount of inflation needed to reduce unemployment will vary. If we are very low on the curve, a small amount of inflation will reduce unemployment dramatically; if we are very high on the curve, it would take a large amount of inflation to have any effect on unemployment. Europe's unemployment is high enough right now that they could probably see a fairly significant reduction in unemployment with a small amount of inflation.

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