Question

A central bank can allow its currency to fall indefinitely, but it cannot allow its currency to rise indefinitely. Why not?

Short answer

In summary, a central bank cannot allow its currency to appreciate indefinitely due to the negative consequences on export competitiveness, economic growth, and potential disinflation or deflation. Furthermore, it needs to maintain economic stability by managing external shocks and accumulating foreign exchange reserves as a buffer against vulnerabilities.

Step-by-step solution

Understanding exchange rate policies

First, let's understand the concept of exchange rate policies. A central bank may use one of the following types of exchange rate policies: 1. Floating exchange rate: The exchange rate is determined by market forces of supply and demand for the currency. 2. Fixed exchange rate: The central bank pegs its currency to another currency or a basket of currencies, trying to maintain a constant value of its currency. 3. Managed float (dirty float): The central bank occasionally intervenes in the foreign exchange market to control the value of its currency, aiming to maintain stability in the exchange rate. Central banks intervene in the foreign exchange market to influence the exchange rate in line with their monetary policy objectives, such as controlling inflation, promoting economic growth, or maintaining financial stability.

Consequences of a falling currency

When a country's currency depreciates or falls in value: 1. Exports become cheaper: A lower exchange rate makes a country's goods and services more competitive in international markets, thereby increasing exports and boosting economic growth. 2. Imports become more expensive: As the domestic currency loses value, imported goods and services become more expensive, which may lead to inflation and reduce consumer spending on imported products. 3. Foreign debts burden: Domestic debts denominated in foreign currencies become more expensive as the currency falls, which can impact businesses and governments' ability to service their foreign-denominated debts.

Consequences of a rising currency

When a country's currency appreciates or rises in value: 1. Exports become more expensive: A higher exchange rate makes a country's goods and services more expensive in international markets, making them less competitive, reducing exports and hindering economic growth. 2. Imports become cheaper: As the domestic currency gains value, imported goods and services become cheaper, which may lower inflation and increase consumer spending on imported products. 3. Ease of foreign debt burden: Domestic debts denominated in foreign currencies become less expensive as the currency appreciates, which can ease the financial burden on businesses and governments with foreign-denominated debt.

Reasons why central banks cannot let their currency appreciate indefinitely

Given the consequences of a rising currency, central banks cannot allow their currency to appreciate indefinitely because: 1. Economic growth concerns: Continued appreciation of the domestic currency may have a detrimental impact on a country's exports, leading to job losses and lower economic growth. 2. Disinflation or deflation: If the currency appreciation leads to lower import prices, it may result in disinflation or deflation if demand for goods and services remains weak, which can further hurt the economy. 3. Mitigating external shocks: Central banks may need to intervene in case of external shocks, such as capital inflows or sudden changes in global economic conditions, that could cause the currency to appreciate too rapidly and create imbalances in the economy. 4. Foreign exchange reserve accumulation: Unlimited appreciation would limit the central bank's ability to build foreign exchange reserves, an essential buffer against external shocks and vulnerabilities. In conclusion, a central bank can allow its currency to fall to stimulate economic growth and control inflation, but it cannot allow its currency to appreciate indefinitely due to concerns about exports, disinflation or deflation, and maintaining economic stability.