Interest rates and exchange rates are the two lifelines of a country’s economy. Any movement in either one directly affects the stock market, property market, corporate profitability, and even the value of the money in our pockets. Achieving the right balance between these two forces is the core responsibility of a central bank through its dual-rate policy (which coordinates interest rate policy and exchange rate policy). This policy is much like walking a tightrope: on one side is the need to control inflation, and on the other is the need to preserve export competitiveness. What exactly is the relationship between interest rates and exchange rates? How does a central bank manage both to respond to complex economic conditions? This article will take an in-depth look at the Central Bank of Taiwan’s dual-rate policy and reveal how it influences both our investments and everyday lives.
The “dual-rate policy” does not refer to a single policy. Rather, it is a collective term for the central bank’s comprehensive consideration and coordination of two key variables, “interest rates” and “exchange rates” when implementing monetary policy. These two variables are like opposite ends of a seesaw. They constrain and influence one another, and the central bank’s goal is to find the balance point that best serves the overall economy.
Interest rates can be understood as the “price of money”. When you deposit money, the bank pays you interest. When you borrow money, you pay interest to the bank. By adjusting policy rates (such as the discount rate), the central bank can directly influence the cost of funds throughout the financial system and achieve its policy objectives.
How Do Interest Rate Hikes Affect the Economy? Understanding the Transmission Mechanism at a Glance
The exchange rate refers to the value at which one currency can be exchanged for another, such as how many New Taiwan dollars can be exchanged for one US dollar. Changes in exchange rates have a direct impact on Taiwan’s import and export industries.
To understand the challenges of the dual-rate policy, it is essential to understand the famous economic theory known as the “Impossible Trinity”, also called the “Trilemma”. Developed by economists Robert Mundell and Marcus Fleming, the theory states that a country cannot simultaneously achieve all three of the following monetary policy objectives:
The Impossible Trinity: The Eternal Triangle of Monetary Policy Challenges
A country can choose at most two of these three objectives. For example, Hong Kong has chosen exchange rate stability (the Linked Exchange Rate System) and free capital movement, which means it must give up an independent monetary policy. As a result, its interest rate policy must closely follow that of the US Federal Reserve. By contrast, Taiwan has chosen independent monetary policy and free capital mobility. This means it must give up a fixed exchange rate and instead adopt a “managed floating exchange rate system”. This is the fundamental reason why Taiwan’s central bank must continually balance its dual-rate policy. Readers seeking a more academic explanation of this theory may refer to the relevant Wikipedia entry.
According to the statutory responsibilities of Taiwan’s central bank, its monetary policy objectives are multifaceted, including promoting financial stability, maintaining sound banking operations, preserving price and exchange rate stability, and supporting economic development under these conditions. To achieve these goals, which can sometimes conflict with one another, the central bank maintains a diverse policy toolkit.
The objectives of Taiwan’s monetary policy are explicitly stipulated in Article 2 of the “Central Bank Act”. In summary, its core responsibilities can be categorized as follows:
To regulate both the “quantity” and “price” of money in the market, the central bank primarily utilizes the following three interest rate tools:
Although Taiwan adopts a managed floating exchange rate system, the central bank does not take a completely hands-off approach. When short-term market disorder or speculative activity causes excessive volatility in the New Taiwan dollar, the central bank may “intervene”, a practice often referred to as the “Willow Theory” or “counter-cyclical intervention”.
The central bank’s objective is not to reverse long-term trends but rather to “maintain market order and dynamic stability”, preventing excessive volatility from disrupting the real economy.
Ideals are ambitious, but reality is often far more constrained. When implementing a dual-rate policy, central banks frequently face the dilemma that “you cannot have your cake and eat it too”. These trade-offs are what make dual-rate policy one of the greatest tests of policymakers’ judgment, and they are also a key area that investors should monitor closely.
This is the most classic dilemma faced by Taiwan as a small open economy. Suppose the country is experiencing severe inflation. According to economic theory, the central bank should “raise interest rates” to suppress demand. However, once Taiwan’s interest rates exceed those of major economies such as the US, international hot money may be attracted to Taiwan in pursuit of higher interest rate differential returns. Large-scale capital inflows increase demand for the New Taiwan dollar, resulting in “Taiwan dollar appreciation”.
The Central Bank’s Balancing Act: The Difficult Choice Between Controlling Inflation and Supporting Exports
Taiwan dollar appreciation is a major challenge for Taiwan’s export-oriented technology sector, machine tool industry, and other export-driven industries because higher product prices weaken international competitiveness and may even erode corporate profits. Therefore, when deciding whether to raise interest rates to curb inflation, the central bank must simultaneously evaluate the impact on exchange rates and the ability of export industries to absorb the pressure. This is also one of the reasons why Taiwan’s pace of interest rate hikes has often been relatively moderate during global tightening cycles.
Another common conflict occurs in the property market. When the housing market overheats and speculative activity becomes excessive, the central bank may adopt “selective credit controls” or consider “raising interest rates” to increase borrowing costs for homebuyers and cool the market.
However, raising interest rates is a broad and indiscriminate tool. It not only affects property speculators but also increases borrowing pressure on first-time homebuyers and businesses. For companies seeking financing for expansion, higher interest rates reduce investment incentives and may ultimately drag down overall economic growth. Therefore, the central bank must make difficult choices between “property market regulation” and “supporting economic growth”.
Beginning in 2022, the US Federal Reserve (Fed) launched a series of “aggressive rate hikes” to combat the most severe inflation in forty years, rapidly raising the federal funds rate from near-zero levels. This created significant challenges for central banks around the world, including Taiwan.
Faced with this dilemma, Taiwan’s central bank ultimately chose a “middle path” by adopting a “moderate and gradual” interest rate hiking strategy. The magnitude and frequency of Taiwan’s rate hikes were far lower than those of the US. The primary objective was to narrow part of the interest rate differential and slow the pace of capital outflows, with “exchange rate stability” serving as one of the key priorities, while also avoiding excessive damage to Taiwan’s fragile economic recovery. This case perfectly demonstrates the flexibility and pragmatic approach of Taiwan’s central bank in implementing its dual-rate policy. At its core, every policy decision revolves around the principle of “stability”.
A: Taiwan currently adopts a “managed float exchange rate system”. In theory, the exchange rate of the New Taiwan dollar is determined by market supply and demand. However, when excessive volatility or irrational speculative activity occurs in the market, the Central Bank may intervene to maintain market order. Therefore, it is neither completely fixed nor completely freely floating.
A: Based on his public speeches and legislative reports over the years, the core principle of Governor Yang Chin-Long’s dual-rate policy is “maintaining dynamic stability”. He has repeatedly emphasized that Taiwan is a small and highly open economy that is easily affected by international developments. Therefore, monetary policy must remain flexible and adopt “counter-cyclical operations” when appropriate to mitigate external shocks. His decision-making style tends to be prudent and pragmatic, avoiding abrupt policy shifts while striving to balance multiple objectives (including price stability, economic growth, and financial stability).
A: This is primarily due to the fundamental differences in the economic structures and financial environments of the two countries. First, Taiwan has maintained a very high household savings rate for many years, resulting in relatively abundant market liquidity and reducing the need for high interest rates to attract savings. Second, Taiwan’s inflation rate has historically been lower than that of the US, making it unnecessary to adopt interest rate policies as aggressive as those in the US. Finally, Taiwan’s economic growth relies heavily on exports, and excessively high interest rates could cause excessive Taiwan dollar appreciation, which would be detrimental to industrial development. As a result, the Central Bank sets interest rates according to domestic economic conditions rather than blindly following the US.
A: In most cases, yes. According to the “interest rate parity theory”, when a country raises interest rates and offers higher yields than other countries, it attracts capital inflows, which can drive its currency higher. However, this is not absolute. Exchange rates are influenced by many factors including economic prospects, stock market performance (whether foreign investors are net buyers or net sellers of Taiwan stocks), geopolitical risks, and global risk sentiment. In some cases, even if the Central Bank raises interest rates, the Taiwan dollar may still depreciate if foreign investors move substantial capital out of Taiwan due to a negative outlook for the stock market. Therefore, interest rates are only one of many important factors affecting exchange rates, not the sole determinant.
The dual-rate policy is a sophisticated balancing act performed by the Central Bank in a complex and constantly changing economic environment to maintain stability. It involves trade-offs and challenges, and no single policy decision can satisfy everyone’s expectations. Interest rate adjustments affect the costs faced by savers, borrowers, and businesses, while exchange rate fluctuations influence exporters’ profitability and the prices of imported goods. Understanding the coordination and conflicts between interest rates and exchange rates, as well as the Central Bank’s efforts to balance multiple objectives such as “price stability”, “export competitiveness”, “financial stability” and “economic growth” can help us better anticipate future economic trends and the Central Bank’s next moves. This, in turn, enables more informed investment and financial planning decisions. It is not merely a subject for economists, but an essential element of financial literacy for every modern citizen.
