The Role Of Central Banks In International Money Transfers: Understanding Monetary Policy, Exchange Rates, And More

Ever wondered how your money zips across borders in the blink of an eye? And what about those ever-changing exchange rates — who sets them? In a world where transactions span continents in seconds and currencies shift with market whims, central banks play a vital role in orchestrating international money transfers.

Central Banks play a multifaceted role in facilitating and regulating international money transfers through their influence on monetary policy, currency stability, and the overall financial system.

But don’t click away just yet, because there’s a lot more to learn about how central banks shape monetary policy, impact exchange rates, and most importantly, how these factors affect your international money transfers.

Let’s start with the basics.

Table of Contents

What is Monetary Policy?

Monetary policy refers to a set of strategic actions taken by a country’s central bank to regulate the supply of money and control the cost of credit in the economy. These policies are usually put in place to steer a country’s economy toward specific objectives.

The primary objectives of monetary policy typically include:

Price stability. This involves controlling inflation, which is the rate at which the general level of prices for goods and services is rising.

Full employment. Central banks typically aim to achieve maximum sustainable employment within an economy.
Economic growth. Monetary policy can influence economic activity by stimulating or dampening consumer and business spending.

Understand that different countries may have varying objectives for their monetary policies depending on their economic conditions, priorities, and other factors. So while the objectives I mentioned earlier are common across many central banks, the relative emphasis placed on each can vary depending on the country’s economic goals.

For example, a country facing high inflation may prioritize price stability as its primary goal and implement a contractionary policy to reduce inflation rates. In contrast, a country experiencing high unemployment may prioritize full employment and implement an expansionary monetary policy to stimulate economic activity and job creation.

Wondering, “What are expansionary and contractionary policies?”

They’re the two broad categories monetary policies generally fall under. Here’s a closer look at each:

Expansionary Monetary Policy

Expansionary monetary policy is the government’s way of giving the economy a redbull to get it soaring again. It’s a set of actions taken by a country’s central bank to breathe new life into the economy after a crisis or amp up growth when things aren’t moving as fast as they need to be.

This type of monetary policy is typically set into action when economic activity hits a major slump (like during a recession). Its ultimate goal is to pump up the overall demand for goods and services within the economy, creating a better environment for businesses to thrive and people to find jobs.

To achieve that goal, central banks take strategic actions to increase the supply of money and credit in the economy.

Those strategic actions might involve:

Lowering Interest Rates

Interest is basically the cost of credit. So when central banks lower interest rates, they reduce the cost of borrowing money for businesses and individuals. This decrease in borrowing costs incentivizes businesses to invest in new projects, expand operations, and hire more workers. The net result of this? You guessed it! An increase in economic activity.

For individuals, lower interest rates mean cheaper loans for buying homes, cars, or other big-ticket items. This increased spending has a domino effect throughout the economy; it boosts demand for goods and services, which in turn spurs economic growth.

Lower interest rates can also have a positive impact on asset prices, such as stocks and real estate. With borrowing costs down, investors might feel more inclined to pump money into real estate or the stock market, pushing up the demand for those assets along with their prices. This can further stimulate consumer spending and investment, contributing to economic expansion.

Last but not least, lowering interest rates helps weaken a country’s currency in the foreign exchange market. That might not sound great at face value, but it’s actually a good thing for exports. A weaker currency makes exports more competitive in international markets, potentially boosting demand for domestically produced goods and services abroad. This increase in exports can help support economic growth by stimulating production and creating jobs in export-oriented industries.

Open Market Purchases

This is another tool central banks use to manipulate the supply of money and the cost of credit in an economy. As the name suggests, it describes the act of a country’s central bank buying financial assets (such as government bonds or other securities) on the open market.

How does this help revitalize an economy?

Well, when the central bank buys financial assets from banks or other financial institutions, it injects cash into the financial system. This increases the cash reserves of banks and financial institutions.

With more cash on hand, banks and financial institutions are inclined to lend it out to businesses and individuals. This increased supply of loans tends to lower interest rates because lenders typically have to compete to attract borrowers. Lower interest rates make borrowing cheaper, encouraging businesses to invest in expansion and individuals to make big-buck purchases like homes or cars.

Banks and other financial institutions may also choose to invest the extra cash in other assets, like stocks or real estate. Pouring money into these markets pushes up prices and makes everyone feel a bit wealthier. This “wealth effect” can encourage people to spend more, further boosting economic activity.

Lowering Reserve Requirements

Banks usually have to keep a certain percentage of their total deposits in reserve. This percentage is usually set and enforced by the central bank through monetary policy decisions.

Why would the central bank require banks to keep a percentage of their deposits in reserve?

A couple of reasons.

First off, imposing reserve requirements keeps banks liquid enough to meet their obligations. Banks need to have readily available funds to cover customer withdrawals and other short-term obligations. Keeping a portion of their deposits in reserve allows them to meet these obligations without having to sell off assets or rely on borrowing in times of high demand.

Reserve requirements also help stabilize the financial system by preventing banks from overextending themselves and becoming insolvent. Requiring banks to hold reserves reduces the risk of a liquidity crisis and helps maintain the stability and integrity of the banking system.

Last but equally important, reserve requirements play a key role in supporting monetary policy. Central banks use changes in reserve requirements as a tool to influence the money supply and credit conditions in the economy. By adjusting reserve requirements, central banks can affect the amount of lending and borrowing in the banking system, which in turn impacts economic activity and inflation.

During an expansionary phase, when the goal is to increase the supply of money and credit in the economy, central banks may lower reserve requirements. That leaves banks with more money to lend out to people and businesses, which helps stimulate economic growth.

Providing Forward Guidance

Forward guidance is basically a heads-up from the central bank about what they’re planning to do with interest rates in the future. It’s yet another tool central banks use to influence market expectations and consumer behavior.

How do they use it to support an expansionary monetary policy?

Simple: They drop hints that they’re going to keep interest rates low for a while. That encourages businesses to borrow money for investments and nudges people to buy houses or cars because they know borrowing will still be cheap. At the risk of sounding like a broken record, this increased spending and investment perks up the economy.

Quantitative Easing (QE)

Central banks typically turn to quantitative easing when conventional monetary policy measures, like tinkering with interest rates, no longer cut it. This last-resort move aims to provide additional monetary stimulus to the economy to get the wheels turning again.

When central banks use quantitative easing, they essentially create new money electronically. This freshly minted cash is then used to buy financial assets like government bonds, corporate bonds, or mortgage-backed securities from banks and other financial institutions.

Buying up these assets increases their demand, which drives up their prices. As bond prices rise, their yields (or interest rates) fall. This decrease in long-term interest rates makes borrowing cheaper for businesses and individuals, encouraging spending and investment.

QE also tends to bump up the prices of other assets, like stocks and real estate. When central banks buy bonds, they inject money into the financial system. Some of that money finds its way into other investments and pushes their prices higher.

The ultimate goal of QE is to support economic recovery by encouraging borrowing, spending, and investment. Lowering interest rates and boosting asset prices stimulates economic activity, create jobs, and prevent deflation.

So why is QE considered an unconventional monetary policy tool if it indirectly affects interest rates?

Several reasons:

It involves large-scale purchases of financial assets by central banks. These purchases are typically much larger than those made through traditional open market operations, making QE a more drastic and unconventional measure.
It primarily targets long-term interest rates rather than short-term rates (which are the primary focus of traditional monetary policy tools). This focus on long-term rates is unconventional compared to the more common practice of adjusting short-term rates.
It leads to a significant expansion of the central bank’s balance sheet as it accumulates large amounts of assets. This expansionary effect on the central bank’s balance sheet is unconventional and can raise concerns about potential risks and distortions in financial markets.
Its effects can be unpredictable. QE can sometimes have unintended consequences on financial markets and the economy due to its unprecedented scale and scope. Sure, it aims to stimulate economic activity, but there may be side effects such as asset price inflation, distortions in financial markets, or moral hazard concerns.

It may be less effective in certain economic conditions. This is particularly true when interest rates are already very low or when there are structural constraints on borrowing and lending. In such cases, the unconventional nature of QE may not produce the desired economic outcomes.

Contractionary Monetary Policy

A contractionary monetary policy does the exact opposite of its expansionary counterpart: it aims to curb inflationary pressures and stabilize prices by slowing down economic activity. These policies propose strategic actions to decrease the supply of money and credit in the economy, which raises interest rates and discourages borrowing and spending.

Central banks typically turn to this type of monetary policy during periods of high inflation or economic overheating. They rely on pretty much the same tools they would for an expansionary policy, but this time, they use them in reverse by:

Raising interest rates to make loans more expensive. This makes it less appealing for people and businesses to take out loans, which slows down spending and investment.
Executing open market sales. Instead of buying as they would with an expansionary policy, central banks sell government bonds and other assets to take money out of the economy. This reduces the amount of money available for lending, which also helps slow down economic activity.
Raising reserve requirements. As I mentioned earlier, banks are usually required to keep a certain amount of money in reserve. A contractionary monetary policy raises that figure, cutting down the amount of money banks can lend within legal limits. The net result? Reduced borrowing and spending.
Using forward guidance to signal their intention to raise interest rates in the future. This discourages borrowing, spending, and investment. It’s worth mentioning that this tool is less commonly used to support contractionary monetary policy. Central banks generally favor more direct measures like the ones we’ve discussed above.

Notice that I didn’t include Quantitative Easing here? It’s for a reason. Unlike the other tools, QE doesn’t have a “reverse gear”. It’s strictly reserved for stimulating economic activity and increasing inflationary pressures, which is the exact opposite of what contractionary monetary policy does.

What Are Exchange Rates?

Exchange rates refer to the value at which one currency can be exchanged for another currency. They’re basically price tags on currencies in the global marketplace; they indicate how much of one currency you need to purchase a unit of another.

Exchange rates are typically expressed as the amount of one currency required to purchase a unit of another currency. For example, if the exchange rate between the US dollar (USD) and the euro (EUR) is 1.20, it means that one US dollar is equivalent to 1.20 euros.

Central banks generally use one of the following three systems to determine the value of their currencies against other currencies:

A Floating exchange rate system. Also known as flexible exchange rates, rates set under this system are determined by supply and demand in the foreign exchange market. Central banks may intervene occasionally to smooth out excessive fluctuations, but they don’t commit to maintaining a specific rate. Exchange rates under this system can be more volatile because they’re affected more by economic conditions, market sentiment, and external factors.
A fixed exchange rate system. Under this system, the value of a currency is pegged to another currency, a basket of currencies, or a commodity like gold, and the central bank commits to maintaining that fixed rate. This commitment means that the central bank will intervene in the foreign exchange market as needed to keep the exchange rate within the specified range. That limits exchange rate fluctuations, providing a high level of stability for businesses and individuals engaging in international trade and investment.
A managed float system. This is a mix of the two systems above. While the exchange rate is allowed to fluctuate within a certain range, the central bank steps in every now and then to keep it from going too crazy. These systems provide some flexibility while still maintaining some control over currency values, but they may not offer the same level of stability as fixed exchange rate systems.

The Role of Central Banks in International Money Transfers

As I went on and on about exchange rates and monetary policy, you probably wondered, “What does this have to do with international money transfers?” It’s a valid question given the mouthful of economics jargon I’ve put you through, but hang in tight; it’s all about to start making sense.

Central banks play several roles in international money transfers:

They Manage Exchange Rates

We touched on this when we talked about exchange rates, but it never hurts to hammer an important point home.

Central banks, as the primary monetary authorities of a country, have the power to directly or indirectly manipulate exchange rates. They influence exchange rates through their monetary policy decisions, like adjusting interest rates, engaging in open market operations, and so on.

This affects how much your money is worth when you transfer it to another currency, which ultimately factors into the total cost of your transaction:

A stronger domestic currency means that it takes fewer units of that currency to purchase another currency, making international transactions cheaper for those holding the stronger currency.
A weaker domestic currency requires more units of that currency to buy another currency, increasing the cost of international transactions for holders of the weaker currency.

So the next time you send money abroad, you can thank (or blame!) your central bank for the exchange rate you get.

Central banks’ monetary decisions also dictate how reliably a country’s currency maintains its value. Case and point? The choice of exchange rate system. The type of system a country puts in place affects the stability of its currency’s value in the global market: fixed rate systems offer the most stability, and the reverse is true for floating rate systems.

What does a currency’s stability have to do with international money transfers?

Well, when a currency reliably maintains its value in the foreign exchange market, it provides a sense of security for businesses and individuals engaging in international transactions.

Here’s what I mean by that:

Stable exchange rates mean businesses can more accurately predict their costs and revenues when trading with foreign partners or purchasing goods and services from abroad. This stability reduces uncertainty and helps businesses make informed decisions regarding investments and expansion into global markets.

For individuals sending money across borders, a stable currency value ensures that the amount they send retains its purchasing power when converted into foreign currency. Whether it’s sending money to family members overseas, making international investments, or traveling abroad, knowing that their money will hold its value provides peace of mind and financial security.

They Provide Regulation and Oversight

Central banks are the custodians of regulations governing international money transfers. They don’t just set the rules of play for all parties involved in international money transfers; they also coordinate with domestic law enforcement agencies and international regulatory authorities to make sure everyone follows them.

This helps prevent sketchy dealings like money laundering and fraud, making sure your hard-earned money stays safe and legit as it hops around the globe.

They Help Run Cross-Border Payment Systems

Cross-border payment systems are the infrastructure and networks that facilitate the transfer of funds and settlement of transactions between individuals, businesses, and financial institutions located in different countries. Without them, cross-border transactions wouldn’t be possible.

Now, central banks aren’t the only party involved in running these systems. They coordinate with:

Financial institutions such as banks.
Payment service providers, including remittance companies, money transfer operators, and fintech firms.
International organizations, like the Society for Worldwide Interbank Financial Telecommunication (SWIFT) and regional payment associations.
Other regulatory authorities (central banks act in a regulatory capacity, remember?) such as domestic financial regulators and international bodies like the Financial Action Task Force (FATF).

Although central banks aren’t the only ones in the mix, they’re indispensable players in keeping cross-border payment systems running. Without them, the world of cross-border payments would be a lot more chaotic!

In addition to providing regulatory oversight to keep things legit and prevent any shady business, central banks play other super-important roles in running cross-border payment systems, including:

Providing clearing settlement services for cross-border transactions. Central banks act as intermediaries to facilitate the transfer of funds between financial institutions involved in a transaction. They provide the infrastructure and mechanisms needed for financial institutions to settle their payment obligations with each other, beefing up the efficiency and security of cross-border transactions.
Liquidity management. Central banks manage liquidity in the financial system, ensuring sufficient funds are available for cross-border transactions to settle smoothly and efficiently. They may step in to provide liquidity support to financial institutions participating in cross-border payment systems, especially during periods of market stress or volatility.
Facilitating interbank coordination: Central banks facilitate interbank cooperation to make sure that different payment systems can work together smoothly across borders. They do this by coordinating with various domestic and international stakeholders to standardize protocols and messaging formats, making it easier for transactions to happen quickly and reliably between different countries.
International collaboration. Central banks engage in international cooperation to address cross-border payment challenges and promote innovation in payment systems. They participate in forums and working groups with other central banks, financial institutions, and international organizations to exchange best practices, address emerging issues, and enhance cross-border payment infrastructures.
Promoting financial inclusion. Central banks play a crucial role in promoting financial inclusion by ensuring that cross-border payment systems are accessible to all segments of society, including underserved and marginalized populations. They work to reduce barriers to cross-border transactions, promote the use of digital payment solutions, and enhance the affordability and accessibility of remittance services for migrant workers and their families.