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Bank of Latvia

The Bank of Latvia » For All » Information to the Public » Commentary » 2009 » How the stability of the lats is ensured by the Bank of Latvia

How the stability of the lats is ensured by the Bank of Latvia

The exchange rate of the lats is determined by the central bank, i.e. the Bank of Latvia. The strategy the Bank of Latvia has chosen to follow, to maintain the stability of the exchange rate, has remained unaltered since February of 1994, and there are no other plans. After joining the European Union in 2005, the lats was pegged to the euro at the central parity rate of 0.702804 lats for one euro with an allowed fluctuation band of +/- 1% . The passive inteventions of the central bank ensure that exchange rate does not shift more than 1% above or below this exchange rate, i.e. does not exceed 0.6958 and 0.7098 LVL/EUR, respectively.

The exchange rate mechanism in Latvia is simple and similar to that in countries with a currency board arrangement. It can be compared to the principle of communicating vessels where the lats in circulation correspond to the foreign and gold reserves. The everyday currency exchange transactions are executed by banks and foreign exchange businesses. If there is an increased demand for lats, it is met by the Bank of Latvia that buys foreign currency - it goes into the reserves - and sells lats that are put into circulation. Under normal economic circumstances of economic growth, the amount of lats in circulation grows and the Bank of Latvia's reserves grow accordingly. If there is an increased demand for the euro it is again met by the Bank of Latvia, which begins to buy up lats in exchange for foreign currency from the reserves. That means that the amount of lats in circulation decreases.

The interventions of the Bank of Latvia are passive. If a market participant wishes to engage in foreign exchange transactions at the bid or ask rate set by the Bank of Latvia (0.6958 and 0.7098 LVL/EUR), it can be done at the Bank of Latvia. The volume of such transactions is not limited. Consequently, foreign exchange transactions at rates that are outside the Bank of Latvia's target zone become unprofitable for participants of the currency market.

Since the amount of lats is covered by the reserves, the Bank of Latvia can buy up all the lats in circulation; however, this is rather a theoretical case as such an extreme situation can hardly arise in a real life because a certain amount of lats will always be necessary: for fulfilling the minimum reserve requirements by commercial banks, for paying salaries, to make tax payments, to do shopping etc.

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