Question

An article in the Wall Street journal stated, "The years long battle that smaller European central banks (such as the central bank of Switzerland) have waged against their own strong currencies may have turned a corner, thanks to the strengthening euro." The article further noted that the "Swiss National Bank's foreign-exchange reserves accumulated on a massive scale since 2012 - dipped slightly last month." a. Why would the Swiss National Bank (the central bank of Switzerland) wage a battle against its own strong currency? b. Is there a connection between the Swiss National Bank waging a battle against its strong currency and the Swiss National Bank accumulating massive amounts of foreign exchange reserves? Briefly explain.

Short answer

The Swiss National Bank might want to weaken a strong Franc to make Swiss exports more competitive globally. The accumulation of foreign exchange reserves provides the tool required to intervene in the foreign exchange market, enabling the bank to sell Swiss Francs and purchase foreign currencies. This increases the supply of Francs, lowering its value, hence there's a connection between the two actions.

Step-by-step solution

Understanding the Role of the Swiss National Bank

The Swiss National Bank, like various central banks worldwide, is responsible for managing its country's currency, controlling inflation, and maintaining economic stability. This involves various activities, including managing the value of the Swiss Franc, essentially determining whether it is 'strong' or 'weak.'

Implication of Having a Strong Currency

Generally, a strong currency means it's worth more compared to other currencies. For instance, one Swiss franc might be worth 1.5 US dollars, which means Swiss goods or services become more expensive for foreign buyers. This can negatively impact Swiss exports as it'll be costly for foreign countries to import from Switzerland, reducing Swiss companies' competitiveness on the global market. Hence, the Swiss National Bank might aim to weaken the currency to boost exports and the overall economy.

Relation between a Strong Currency and Foreign Exchange Reserves

Foreign exchange reserves are assets held in different currencies by central banks. By accumulating foreign exchange reserves, the Swiss National Bank can intervene in the foreign exchange market. When it wants to weaken the Swiss Franc, it can sell Francs and buy foreign currencies, increasing the supply of Francs and thus lower its value. Therefore, there's a connection between combating a strong currency and gathering substantial foreign exchange reserves, as the latter gives the central bank a tool to influence the currency's strength.

Key concepts

Swiss National Bank

The Swiss National Bank (SNB) plays a crucial role in the financial and economic framework of Switzerland. Comparable to the task of a helmsman steering a ship through changing tides, the SNB navigates the Swiss economy through global economic fluctuations. It holds the responsibility of shaping monetary policy, issuing Swiss francs, and generally ensuring the smooth operation of payment systems.

Central to its mission is preserving price stability, which often correlates with the value of the Swiss franc relative to other currencies. By carefully adjusting monetary policies, the SNB works to prevent high inflation, which can erode the purchasing power of consumers, or deflation, which might lead to decreased economic activity. An interesting point to note is that, unlike some other countries where the goal includes striving for full employment, the SNB focuses almost exclusively on price stability, trusting that this will, in turn, support the broader economy.

When the SNB intervenes in the currency market, it's often a balancing act. The SNB possesses an array of tools for this, including interest rate adjustments and direct foreign exchange market operations. When we see that the SNB has accrued substantial foreign exchange reserves, we understand that it is poised to react to currency fluctuations that could impact the Swiss economy. Such preparedness allows the SNB to act decisively to maintain economic stability.

Currency Intervention

Currency intervention is a strategic tool used by central banks, like the SNB, to adjust the value of their nation's currency. The motives for such interventions are manifold, but the central theme is to align the currency's value with the country's economic objectives.

How does this process unfold? When a currency is deemed too strong—as has been the case for the Swiss franc—the SNB may step into the market to 'weaken' the franc. By purchasing foreign currencies in exchange for Swiss francs, the bank increases the supply of francs in the market, leading to a decrease in its value. Conversely, if the franc was too weak, the SNB might buy Swiss francs with its foreign reserves, reducing the supply and driving up its value.

By influencing the exchange rate, the SNB can make Swiss exports more competitive, if the currency is weakened, or protect consumers' purchasing power abroad, if the currency is strengthened. The following succinctly outlines the seesaw balance of currency intervention: weaken for export competitiveness, strengthen for purchasing power.

Economic Stability

Economic stability is the cornerstone of a nation's prosperity, and central banks are the guardians of this stability. In the case of the SNB, maintaining economic stability means avoiding erratic swings in inflation and ensuring that the currency's value doesn't impede economic growth.

Why is a stable economy so essential? When businesses and consumers can predict the general direction of inflation and currency value, they can make informed decisions about investing, hiring, and spending. This confidence fosters a healthier economy. Instability, on the other hand, can lead to speculative behaviors, reduced investment, and haphazard government policies. For small, open economies like Switzerland's, with a significant reliance on global trade, stability becomes even more critical.

In achieving stability, the SNB balances internal interests, such as price level and employment, with the external pressure of currency markets. The interplay between these domestic and international aspects is complex, as the SNB's manipulation of currency directly affects trade relations. When the SNB's efforts culminate in a stable economic environment, the entire country benefits—businesses, investors, and everyday citizens alike can prosper with a foundation of predictability and orderliness in the economic landscape.