The purchasing of domestic or foreign currency is an approach used by the central bank in countries with fixed exchange rates to keep the rate stable.
To maintain the exchange rate, the central bank will buy its own currency when the demand for it is low. For example, the country in question is country A, with an exchange rate of 2units(U) per dollar(S)–U2=$1. If A has more imports than exports, or if residents of A are buying more foreign capital and financial assets than foreigners are buying capital and financial assets in A, then the central bank will buy domestic currency. This would prevent A’s currency from depreciating, from U2=$1 to U1.5=$1 for instance.
Meanwhile, if there is an increased demand for A’s currency, the central bank will purchase foreign currency. This occurs if A has more exports than imports, and foreigners are buying more capital and financial assets in A than residents are buying capital and financial assets from abroad. This is done to prevent the currency from rapidly appreciating.
In essence, it is just a matter of supply and demand. A good is priced low if the demand for it is less, while it becomes expensive if the demand for it is high. In this analogy, the exchange rate is the price of the currency. When the need for domestic currency declines, its price decreases. (i.e. the exchange rate depreciates). If there is a huge demand for the currency, its price rises( i.e. the exchange rate appreciates). Thus, central banks have to interfere.
Investment decisions actually depend on the risk appetite of a firm. If a firm is risk averse, meaning it is not willing of take chances with gaining or losing an unpredictable amount of money from foreign exchange fluctuations, it should repatriate its profits. If the income is to be immediately repatriated, the spot rate would apply, and since tax rates are set, the amount to be received is calculated.
If the firm would reinvest its profits, it is advisable to use hedging to lessen the risk of losses from fluctuating exchange rates. This is applicable to manufacturing companies that purchase its raw materials from different locations. If the domestic currency depreciates, the cost of its imported components increases.
But, the choice of whether to reinvest or repatriate is complex one. Several factors come into play. The choice of investment affects the decision– will the company invest in financial markets like stocks, or is it going to put its money in the production of goods? The environment is another factor to be considered—is the political situation in the country stable enough to keep the exchange rate from abruptly depreciating?
Blanchard, O. (2002) Macroeconomics(3rd Ed).USA:Prentice Hall
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Topic: The purchasing of domestic or foreign currency
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