Why The Simultaneous Targeting of The Money Supply and Interest Rates Is Sometimes Impossible to Achieve?
Because the variables are many during the process. According to the model of demand and supply, the equilibrium price is determined by demand and supply. Although we can control the supply and the interest rates, the demand is still out of control. The demand can be affected by any natural events, expectations, and even just emotions. We just cannot control everything in every moment.
Theoretically, demand and supply cross at an equilibrium price point. But, in the real world, it's not always that simple. Mostly, the prices are like waves on the sea. Not to mention we are just able to partly control the supply and the interest rates, but not totally control everyone's brain. Can central banks control your demand in food, water, safety, and investment? Of course not.
How Central Banks Intervene in Foreign Exchange Markets?
Central banks sometimes try to achieve their goals by intervening in foreign exchange markets. It's a monetary policy tool used by central banks, mostly to stabilize the exchange rate, also to build reserves, or provide them to the country's banks. Central banks can buy or sell foreign currency in foreign exchange markets. But, it must be careful to minimize unintended effects. There is no guarantee that traders can look for the new trend to emerge before placing a trade.
The most difficult parts of doing this were the timing and the amounts. Act too early or too late, too much or not enough, all have their pros and cons. However, currency stabilization still requires short-term or long-term interventions. Countries that are heavily reliant on exports may do not want to see that their currency is too strong for other countries to afford the goods they produce. So, they intervene to keep the currency at a lower level.
For example, in 2015, the Swiss National Bank set a minimum exchange rate between the Swiss Franc and the Euro to keep the Swiss Franc from strengthening beyond an acceptable level for other European importers of Swiss goods. Nevertheless, foreign exchange interventions can be risky in that they can undermine a central bank's credibility if it fails to maintain stability.
The Bretton Woods Agreement
The Bretton Woods agreement of 1944 replaced the gold standard with the U.S. dollar as the global currency, and established America as the dominant power in the world economy. The agreement also created the World Bank and the International Monetary Fund (IMF) to monitor the new system.
Under the agreement, these participated countries promised that their central banks would maintain fixed exchange rates with the US dollar. That means these central banks would have to actively buy up or sell short their currency in foreign exchange markets. Purchasing or selling a currency would lower or higher the supply of the currency, and then raise or reduce its price. This is a monetary policy often used by central banks to control inflation.
Obviously, the agreement created more demand for dollars, even though its value remained the same. But, why did they do that? Until World War I, most countries were on the gold standard, a standard built on the supply of gold and the ratio to exchange it. That generates an obvious issue. How can we control the supply of gold? This basically gives up an effective monetary policy tool. Therefore, they cut the tie to gold so they could print the currency needed to pay for their war costs. However, money does not grow on trees. This quick inflow of currency caused hyperinflation, so returned to hug the gold after the war, until the Great Depression.
Nonetheless, the agreement collapses. In 1971, the United States suffered from massive unemployment and low economic growth. President Nixon started to deflate the dollar's value in gold since the dollar was pegged to the price of gold. By 1973, the Bretton Woods system was replaced de facto by the current regime based on freely floating fiat currencies.
Reference
Amadeo, K. (2020, September 03). How a 1944 Agreement Created a New World Order. Retrieved October 12, 2020, from https://www.thebalance.com/bretton-woods-system-and-1944-agreement-3306133
Chen, J. (2020, September 16). Foreign Exchange Intervention Defintion. Retrieved October 12, 2020, from https://www.investopedia.com/terms/f/foreign-exchange-intervention.asp
Wright, R.E. & Quadrini, V. (2009). Money and Banking. Saylor Foundation. Licensed under Creative Commons Attribution-NonCommercial-ShareAlike CC BY-NC-SA 3.0 license.
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