Forex Fundamental Analysis

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Monetary Policy

Before we go delve into economic reports, we must first understand the role of Central Banks.

These entities are the most important players in the Forex market since their actions directly affect currency values. In the US, the central bank is referred to as the Fed or the Federal Reserve Bank.

So what do Central Banks do?

In most countries, it is the principal financial authority. It is responsible for balancing consistent economic growth, inflation and employment rates. Central banks achieve this by controlling the cost of borrowing money. This is referred to as Monetary policy, which differs from Fiscal policy, where the government influences the economy through taxing and spending.

When talking about Monetary policy, you may often hear it referred to as expansionary or contractionary.

  • Expansionary policies decrease interest rates to combat unemployment and jumpstart the economy. Since the financial crisis of 2008, most central banks have pursued aggressive expansionary policies to slow down the recession. The hope is that lower interest rates or lower borrowing cost will entice businesses to expand.

    As Forex traders, this is important because during an expansionary policy, the central bank decreases interest rates, increasing the money supply and, in turn, decreasing the value of its currency. So if you can predict that the Central Bank is going to switch to or increase the rate of its expansionary policy, then it’s time to sell the currency.

  • Contractionary policies, on the other hand, increase interest rates to curb inflation. Though contractionary policies slow down economic growth, it is important to implement them to avoid speculative bubbles such as the “Dot-Com bubble” of the year 2000.

    For us traders, contractionary policies mean that the central bank will buy and hold its currency which, in turn, increases its value. So, if you see any indication that the central bank is going to slow down the economy with a contractionary policy, it is time to buy the currency of that country.

In the next section, we will learn how Central Banks execute these policies.

Monetary Policy

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