By James Stanley, Trading Instructor, FXCM

Central bankers are tasked with the role of governing an economy in an attempt to ensure financial stability. After The Great Depression was initiated by Black Tuesday (October 29, 1929), it became clear that politicians and policy makers did not want to leave economic prosperity to luck and chance. They wanted to be able to control the economy in an effort to prevent another Great Depression.

From the smoldering ashes of The Great Depression came change.

The Federal Open Market Committee (FOMC) was created within The Federal Reserve in response to The Great Depression with the Banking Act of 1933. The FOMC has been charged with the mandate of setting target interest rates for the United States economy. They do this by modifying the Federal Funds Rate (the rate that banks charge each other for overnight loans). This 'base,' interest rate functions in numerous capacities.

If the FOMC desires more growth, they can lower interest rates in an effort to spurn large-scale purchases like homes, automobiles, and real estate.

If, on the other hand, the economy is growing too fast giving rise to fears of future hyperinflation; Central Bankers can look to increase interest rates to make fixed-income investments more attractive. These higher interest rates can often attract capital in an effort to lock-up the higher rate of return. This locked up capital seeps out of the economy, causing growth to slow.

But what happens when this doesn't work?

We've had a really good example of this in The United States over the last two years.

After record-low rates for a record-long period of time, most consumers that wanted to purchase real estate, or automobiles, or homes had already done so. As purchases of these large-ticket items slowed, so did economic growth. As this economic growth continued to slow in the United States, it began to affect other economies as well.

And with rates at near zero percent without the ability to go any lower, the FOMC had to look for creative ways to stimulate the economy, and this is where intervention came into play.

Going into June of 2010 it appeared as though another economic collapse was imminent. Investors, fearful of the reverberations of the 2008 crisis being magnified as this issue was now of a global scale, flocked to 'safe-haven,' investments, such as the United States Treasury Bill. Even though the United States had extremely low interest rates below that of many other modernized nations, investors continued to 'flock-to-safety.'

The beginning of December 2010 saw the EUR/USD currency pair begin trading over 1.50. In very short order we saw the value of the Euro fall 20% as investors sold Euro's to buy U.S. Dollars.

We can see the June 7th low on the chart above, as the currency pair had lost 3,000 pips, or 20% of value in a little over 6 months.

This isn't good for either economy. While it may seem logical that the United States would benefit from a higher valued currency, you have to look deeper. The global economy is so inextricably linked that an economic downturn in Europe would surely affect the United States. So, something needed to be done here before the situation got out of hand and the entire world ended up in a recession that made the 2008 financial crisis look desirable.

The FOMC came out with a policy of 'Quantitative Easing,' commonly called 'QE.' Through Quantitative Easing, the Federal Reserve literally creates money to buy assets (such as long-term bonds) in an effort to inject this newly created capital into the financial system.

This action increases the reserves of banks, allowing them to add liquidity to the system while also increasing demand for the assets they are purchasing. This demand brought on by long-term bond purchases pushes prices higher (and yields lower); liquidity continues to circulate through the system, as banks now have more capital to lend.

And we can see this playing out in the EUR/USD chart for the second half of 2010. After FOMC had intervened in the U.S. Dollar with a policy of Quantitative Easing, the U.S. Dollar begins to weaken as the currency is essentially being diluted with this newly created money.

By the middle of November 2010, the EUR/USD price was back above 1.40; a rise of more than 16% in approximately 5 months. This also prevented the global economic collapse that could have potentially followed had the FOMC chosen not to intervene in financial markets.

The views expressed are not FNArena's (see our disclaimer).

For real time news and analysis, please visit http://www.dailyfx.com/real_time_news

DailyFX provides forex news on the economic reports and political events that influence the currency market. Learn currency trading with a free practice account and charts from FXCM.

www.dailyfx.com

Disclaimer

Forex Capital Markets is headquartered at Financial Square 32 Old Slip, 10th Floor, New York, NY 10005 USA.

Trading foreign exchange on margin carries a high level of risk, and may not be suitable for all investors. The high degree of leverage can work against you as well as for you. Before you decide to trade the foreign exchange products offered by Forex Capital Markets, LLC, Forex Capital Markets Limited, inclusive of all EU branches, FXCM Asia Limited, or FXCM Australia Limited, any affiliates of aforementioned firms, or other firms under the FXCM group of companies [collectively "FXCM Group"] you should carefully consider your objectives, financial situation, needs and level of experience. If you decide to trade foreign exchange products offered by FXCM Australia Limited you must read and understand the Financial Services Guide and the Product Disclosure Statement. FXCM Group may provide general market information and commentary which is not intended to be investment advice and the content of this email must not be construed as personal advice. By trading, you could sustain a total loss of your deposited funds and therefore, you should not speculate with capital that you cannot afford to lose. You should be aware of all the risks associated with trading in foreign exchange products. Foreign exchange products are only suitable for those customers who fully understand the market risk. FXCM recommends you seek advice from a separate financial advisor.

FXCM Group assumes no liability for errors, inaccuracies or omissions in these materials and does not warrant the accuracy or completeness of the information, text, graphics, links or other items contained within these materials. FXCM Group shall not be liable for any special, indirect, incidental, or consequential damages, including without limitation losses, lost revenues, or lost profits that may result from these materials. This email is not a solicitation to buy or sell currency. All information contained in this e-mail is strictly confidential and is only intended for use by the recipient. All e-mail sent to or from this address will be received by the FXCM corporate e-mail system and is subject to archival and review by someone other than the recipient."

Technical limitations

If you are reading this story through a third party distribution channel and you cannot see charts included, we apologise, but technical limitations are to blame.

FN Arena is building the future of financial news reporting at www.fnarena.com . Our daily news reports can be trialed at no cost and with no obligations. Simply sign up and get a feel for what we are trying to achieve.

Subscribers and trialists should read our terms and conditions, available on the website.

All material published by FN Arena is the copyright of the publisher, unless otherwise stated. Reproduction in whole or in part is not permitted without written permission of the publisher.