Using Exchange Rates as Monetary Policy Instruments

March 02, 2015

By Ana Maria Santacreu, Economist

In the past two months, several central banks have unexpectedly intervened in the foreign exchange market, reacting to changes in the world economic environment (low oil prices and a slowdown of world growth) and to announcements by the Federal Reserve and the European Central Bank (ECB). Are these unexpected moves a one-time event, or do they constitute a new way of doing monetary policy? What are the possible consequences of these unexpected moves for other countries trying to defend their currency?

Flexible Regimes

Most central banks have as their mandate keeping inflation low and stable while avoiding large fluctuations in the real economy (such as in unemployment and the output gap). To achieve their objective, they use an instrument, mainly the short-term nominal interest rate, which they increase when the economy is booming (typically when inflation is above its target and the output gap is positive and large) and decrease when the economy is in a recession (typically when inflation is below its target and the output gap is negative). This has been the case for the Fed, the ECB and the Bank of England, among others.

In very open economies—such as Australia, Canada and New Zealand—monetary authorities also care about avoiding large fluctuations in their respective nominal exchange rates, which affect inflation through imports. They change their nominal interest rates when there are fluctuations of inflation and the output gap, as well as the nominal exchange rate.

Fixed Exchange Rate Regimes

Other economies prefer to use the nominal exchange rate as their instrument of monetary policy and commit to keep it fixed to either:

  • One currency, typically the U.S. dollar or the euro
  • A basket of currencies, typically based on their main trading partners

Switzerland has been keeping a minimum exchnag erate with the Euro since September of 2011; in Denmark, the Danish krone is part of the ERM-II mechanism, so its exchange rate is tied to within 2.25% of the euro (the Danish central bank targets a rate of 7.46038 kroner per euro inside a 2.25 percent band).

The monetary authority intervenes in the foreign exchange market to maintain the peg to the announced value.


In between these monetary policy regimes is monetary policy in Singapore. Here, the monetary authority uses the nominal exchange rate as the instrument of monetary policy, but instead of keeping it fixed, it announces a path of the rate allowed for appreciation or depreciation based on changes in economic conditions.


These policies have been successful because of the credibility of the central bank in maintaining the stability of their exchange rates. However, in January 2015, the Swiss National Bank unexpectedly abandoned their minimum exchange rate of 1.20 Swiss francs per euro.1,2 In the same month, the Bank of Canada decreased its interest rate by surprise to 0.75 percent, causing a depreciation of the Canadian dollar.3 Then, the Monetary Authority of Singapore, also in a surprise move, slowed the rate of appreciation of the Singapore dollar.4

What characterizes these policy changes is that they have been unexpected and have shocked the global markets. This is important because:

  • These countries focus on reducing large fluctuations in the nominal exchange rate, and credibility becomes a very important part of a successful monetary policy.
  • Unexpected moves may affect other countries trying to keep their exchange rates stable.

For example, Denmark has reduced its interest rates four times in the past several weeks to defend its peg to the euro.5 Several commentators have argued that if speculators bet that Denmark’s currency peg to the euro will break, this policy could become unsustainable.

Special economic conditions require new monetary policy actions. Whether they are a one-time event or they constitute a new way of doing monetary policy will have an impact on the credibility of future policy announcements.

Notes and References

[1] Switzerland had been keeping a minimum exchange rate with the euro since September 2011. In Denmark, the Danish krone is part of the Exchange Rate Mechanism (ERM II), so its exchange rate is tied to within 2.25 percent of the euro. (The Danish central bank targets a rate of 7.46038 kroner per euro inside a 2.25 percent band.) (“What is ERM II?” European Commission, July 23, 2014.)

2Swiss National Bank discontinues minimum exchange rate and lowers interest rate to -0.75%.” Swiss National Bank Press Release, Jan. 15, 2015.

3 Poloz, Stephen S. “Release of the Monetary Policy Report.” Bank of Canada, Jan. 21, 2015.

4MAS Monetary Policy Statement.” Monetary Authority of Singapore, Jan. 28, 2015.

5 Jolly, David. “Denmark Cuts Rates, Looking to Keep Currency in Check Against the Euro.” New York Times, Jan. 19, 2015.

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