A Central Bank will take a look at how quickly the economy is expanding. This policy is routinely checked so the supply of money within the economy is neither too large, which causes prices to increase, nor too small, which can lead to a drop in prices.
When a Central Bank senses a stagnating economy, they lower interest rates in an attempt to stimulate economic activity. This intervention will increase the money supply.
When a Central Bank senses an over heated economy, they raise short-term interest rates in an attempt to slow economic activity. This intervention in turn decrease the money supply, and is also called a Contractionary Monetary Policy. The inflation level is the main target of a contractionary monetary policy.
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Like all theories, this is generally accurate but it is an oversimplification.
Domestic and Global events also have significant impact., and these include the pace of economic growth, inflation rates, interest rate trends of other large economies such as the European Union, North american and Asian economies.
Left to their own devices, free-market economies tend to be volatile as a result of individual fear and greed, which emerges during periods of instability. History is rife with examples of financial booms and busts but, through trial and error, economic systems have evolved along the way. But looking at the early part of the 21st century, governments not only regulate economies but also use various tools to mitigate the natural ups and downs of economic cycles.
Stay tuned for my next article about the Interest rate differential.
ICYMO here are my previous articles for this FX study guide :
https://www.publish0x.com/foreign-exchange-study-guide/nafta-1994-xwqjqkm(?a=4QbY6P1Odz
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