Question

Why does a central bank care about the exchange rate?

a) To influence inflation rates
b) To impact unemployment rates
c) To regulate interest rates
d) To stabilize foreign reserves

Answer 1

A central bank is concerned with the exchange rate as it can affect aggregate demand, international trade, and cause banking system issues, which impact inflation rates, interest rates, and employment levels.

Step-by-step explanation:

A central bank will be concerned about the exchange rate for multiple reasons. One of the primary reasons is that movements in the exchange rate can affect the quantity of aggregate demand in an economy, which in turn can influence inflation rates. Additionally, substantial fluctuations in the exchange rate can disrupt international trade and cause problems in a nation's banking system. These issues may lead to an unsustainable balance of trade and large inflows or outflows of international financial capital.

In the context of this, a central bank may intervene to stabilize the exchange rate, thereby attempting to manage these economic factors. Moreover, by influencing the exchange rate, a central bank can also affect a country's interest rates and therefore indirectly impact employment levels through the cost of borrowing and the level of investment in the economy.