Final answer:
The countercyclical buffer of Basel III aims to stabilize the banking system by mandating that banks hold a buffer of capital during economic upswings, which can be used in downturns to lessen financial instability and the risk of large exchange rate movements.
Step-by-step explanation:
The purpose of the countercyclical buffer proposed by Basel III is to regulate the quantity of capital banks must hold to protect the wider economy from cyclical economic changes. During periods of high economic growth, banks are required to build up a countercyclical buffer, which can then be drawn down in times of economic stress. This measure helps to reduce international capital flows, particularly short-term portfolio flows, thereby lowering the risk of significant exchange rate fluctuations that could lead to macroeconomic instability.
The countercyclical buffer aims to mitigate the amplitude of financial cycles and foster the stability of the banking system over time. Through this buffer, monetary policy plays a counterbalancing role against the business cycle, loosening during recessions to increase money supply and loan quantity and tightening in times of inflation to decrease money supply and loan quantity.