Question

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

Short answer

A central bank cannot allow its currency to rise indefinitely because it would have severe consequences on the economy. A continuously appreciating currency harms the competitiveness of domestic industries as their goods and services become more expensive for foreign buyers, leading to lower economic growth and higher unemployment. Also, a persistent rise in currency value puts downward pressure on inflation and could lead to deflation, which causes a drop in demand and can result in reduced investments, job losses, and decreased consumer spending, leading to economic stagnation.

Step-by-step solution

Background Information on Central Banks and Exchange Rates

A central bank, sometimes referred to as a reserve bank or monetary authority, is the institution responsible for managing a country's currency, money supply, and interest rates. Some well-known central banks include the Federal Reserve (United States), European Central Bank (Eurozone), and Bank of Japan (Japan). Central banks have several objectives, including maintaining low and stable inflation, supporting economic growth, and ensuring financial stability. One way central banks achieve these goals is by managing their domestic currency exchange rates. An exchange rate is the value of one currency in terms of another currency. For example, if the exchange rate between the U.S. dollar and the Euro is 1.10, it means that 1 U.S. dollar is equal to 1.1 Euros. Exchange rates play a critical role in international trade, foreign investments, and global financial markets.

Implications of Allowing Currency to Fall or Depreciate

A falling or depreciating currency means that the domestic currency is losing value compared to other currencies. From an economic standpoint, a falling currency can bring both advantages and disadvantages. Advantages: 1. Increased competitiveness of domestic industries: A weaker domestic currency makes exported goods and services cheaper for foreign buyers, potentially boosting demand for these products and improving the country's trade balance. 2. Inflation control: By reducing the purchasing power of the domestic currency, a depreciation can help curb inflation, which is particularly helpful in countries facing high inflation. Disadvantages: 1. Increased import costs: A weaker domestic currency makes imported goods and services more expensive, potentially leading to higher inflation if businesses and consumers face higher costs on imported goods. 2. Reduced international purchasing power: A weaker currency reduces the international purchasing power of residents and investors, potentially limiting their ability to invest or buy goods and services abroad. Given the potential advantages and disadvantages, a central bank may sometimes allow, or even actively influence, its currency to depreciate to achieve specific economic objectives.

Implications of Allowing Currency to Rise or Appreciate

An appreciating or rising currency implies that the domestic currency is gaining value compared to other currencies. Similar to a falling currency, there are both advantages and disadvantages associated with a rising currency. Advantages: 1. Lower import costs: A stronger domestic currency reduces the cost of imported goods and services, potentially leading to lower inflation and improving the purchasing power of consumers. 2. Increased international purchasing power: A stronger currency increases the international purchasing power of residents and investors, allowing them to invest or buy goods and services abroad more easily and cheaply. Disadvantages: 1. Reduced competitiveness of domestic industries: A stronger currency makes exported goods and services more expensive for foreign buyers, potentially leading to reduced demand for these products and negatively affecting the whole economy. 2. Deflation risk: An appreciating currency can lower import costs and potentially lead to lower inflation or even deflation, which can be harmful to the economy, particularly if it is accompanied by reduced demand and increased unemployment.

Why a Central Bank Cannot Allow Its Currency to Rise Indefinitely

Allowing a currency to rise indefinitely would have severe consequences for a country's economy. As mentioned earlier, a continuously appreciating currency would hurt the competitiveness of domestic industries, as their goods and services would become more expensive for foreign buyers. This decrease in demand could lead to lower economic growth and higher unemployment levels. Moreover, a persistent rise in the currency value would put downward pressure on inflation and could potentially lead to deflation. Deflation can be detrimental to an economy, as it can cause a drop in demand, leading to reduced investments, job losses, and decreased consumer spending which results in a vicious cycle of economic stagnation. Therefore, central banks have to strike a careful balance when it comes to managing their exchange rates. While it might be appropriate to allow the currency to rise for some period to achieve specific economic objectives (e.g., curbing high inflation), it would not be sustainable for central banks to let their currencies appreciate indefinitely due to the negative economic consequences.