Recently, Japan intervened in the currency market for the first time in six years. Bank of Japan, the Japanese central bank, sold around yen 2 trillion in the currency market to stem an increase in the currency. The logic behind this is simple. A weaker yen will make Japanese exports more competitive, a very important thing for an economy like Japan, which relies on an export-led growth. However, what is the impact of currency intervention on an economy? Does currency intervention lead to global imbalances? In this article, we will look at the impact currency intervention can have.
Firstly, currency intervention is a zero-sum game. The gain made by the country that intervenes in the currency market comes at the expense of another country. Here is why. If Japan intervenes in the currency market by selling yen and buying dollar against it, the yen will become cheaper against the dollar, making Japanese exports to the U.S. cheaper. However, this will also make U.S. exports to Japan more expensive because the dollar has gained against the Japanese yen, resulting in lower exports from U.S. to Japan. Therefore the gains made by the Japanese exporters will come at the expense of U.S. exporters. This could in turn cause current account imbalances.
One major impact of currency intervention is increase in money supply. Therefore if an intervention is not followed by the mopping of excess liquidity, it could stoke inflation. In Japan’s case though, this may not be such a bad thing. However, in general, central banks mop up excess liquidity by issuing bonds to prevent stoking inflation.
Although currency intervention can be beneficial to the intervening country, it comes at a price. Firstly, it can lead to current account imbalances, a situation partly responsible for the recent financial crisis and secondly, the chances of stoking an inflation.
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