In this part you will learn how to profit from trading currencies by understanding the pulse of the underlying forex economics.
If you missed part 1, click here.
We now know the Central Bank of each country is the only entity capable of producing currency.
So how do we measure currency supply?
The monetary base is the amount of currency in circulation.
Economists measure it by compiling statistics from financial institutions (such as amount of deposits).
As was the case with GDP and Current Account balance, any measure of a currency’s monetary base is going to be a lagging indicator and thus, have relatively limited use to a forex trader.
But we don’t need to know the monetary base. We only need to know in which direction the money supply is going.
Central Banks have the mandate to keep monetary stability and facilitate economic growth through monetary policy.
What is monetary policy?
It is the general direction a Central Bank is taking its money supply.
Expansive monetary policy is one in which the Bank increases money supply.
Restrictive monetary policy is when the Bank decreases money supply.
Every Central Bank has the ability to decrease or increase money supply in the economy through several tools at their disposal.
If you understand these mechanisms and the Central Bank’s current economic outlook and monetary policy, you will be in a strong position to determine whether currency supply will increase or decrease.
For example, if the Federal Reserve reduces money supply, then people and organizations won’t have as many dollars in their hands and the price of the dollar will increase.
In this case, assuming everything else equal, a pair such as the EUR/USD would decrease (need fewer dollars per euro), while a pair such as the USD/JPY would increase (need more yen per dollar).
Moreover, what if you are following both the Federal Reserve (USD) and the European Central Bank (euro) and they are implementing opposite monetary policies?
Say the Federal Reserve is decreasing the amount of dollars in the economy.
And the ECB is increasing the amount of euros.
At this juncture you know that dollars will appreciate (increase in price), while euros will depreciate (decrease in price).
Thus, a pair such as the EUR/USD will go down significantly.
Each euro is worth fewer dollars.
Each dollar is worth more euros.
As you can see, having a strong command of these fundamental aspects of forex economics can give you an advantage over other non-professional traders.
But how do we grasp these fundamentals?
We go deeper into Central Bank’s mechanisms here…
And you can find some basic guiding principles below.
Ok, so how can I anticipate a Central Bank’s move?
We go back to their mandates.
In order to keep the economy stable and growing, central bankers keep an eye on different economic indicators.
Remember our friend GDP from part 1?
You may have thought it wasn’t a useful indicator to forex traders because it reflects the past and is thus, not relevant.
Well… not quite.
You see, in order to anticipate the next move in monetary policy, it will serve you well to keep an eye on the economic indicators central bankers are most wary of at that point in time.
GDP, along several other indicators, is one of those central bankers tend to keep an eye on.
Why is this the case?
When a Central Bank changes money supply, what is it afraid of? Why do they do it?
There is a phenomenon called inflation.
When the economy heats up, firms are hiring, and consumers are buying.
This causes prices to go up (increase in demand of goods and services for the existing supply, a shortage, and then prices increase).
If this happens in the economy as a whole, then we have inflation.
Inflation is defined as a general increase in the level of prices in an economy.
Economists measure inflation through an indicator called Consumer Price Index (CPI).
A representative basket of goods is chosen, and its price is measured after each period.
If you are the typical family, buying the typical basket of goods, and you are paying more in the supermarket this year, then it’s likely that the CPI has increased and your economy experienced inflation.
By itself, inflation is neither good nor bad.
The problems arise when it is too high, or too low (as in negative territory, which is called deflation).
So how does inflation interact with GDP and monetary policy?
If nominal GDP is growing too rapidly, a significant portion of that growth might be due to price increases.
Think of GDP as number of goods produced times their average price.
GDP can increase due to an increase in the number of goods produced or an increase in their price, or both (usually both).
But if the majority of growth comes from an increase in price, you may have too much inflation.
This means that people will have to pay significantly more for the same goods.
Imagine yourself paying 10% more on the same groceries you always used to buy.
Since inflation is a generalized measure, you will find it hard to substitute your goods, every brand has gone up.
If inflation is sharp enough, you will find yourself incapable of buying what you used to.
With the same income, you will consume less.
As we know from our GDP equation in part 1, a decrease in consumption from consumers decreases GDP.
In other words, the economy would halt, or even enter a recession.
Firms start firing employees, and people stop shopping as much, they can’t anymore!
Obviously, this goes against the Central Bank mandate to maintain price stability and promote economic growth.
In our modern world, a Central Bank would intervene as soon as it sees any signs of increased inflation.
And so supply meets demand.
For our case, the Central Bank would decrease the amount of money in the economy. People would have fewer dollars in their hands.
There won’t be a shortage of goods (too many people buying), and thus, prices won’t increase too rapidly.
In this way, the change in monetary policy prevented a potential economic recession.
Therefore, if you know the Central Bank is targeting an inflation of 2-3%, and the CPI comes out at 4%, you know this may signal a reduction of money supply in the near future.
A reduction in currency supply will make that currency stronger against other currencies. And you may have a chance to make money forex trading.
Great. But you still haven’t told me how I can best anticipate Central Bank moves.
Do I just look at CPI and GDP? Do I visit their websites?
Check our sections on fundamental analysis, Central Banks, and Economic Indicators.
You can also download our understanding Central
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