What mechanism is used by countries to control the value of their currency?

Sensei answered 5 months ago …

This is a long but simple explanation of complicated economics.

Basically, countries have three means by which they control their currency:

1. The "printing press"
2. "Sterilization"
3. Interest rates.

The Printing Press

Consider currencies like any other commodity. They function on the Law of Supply and Demand. The more of it there is; the less it's worth.

For example, suppose there are $100 Canadian dollars in circulation and $ 100 US dollars in circulation. After "other considerations" have been accounted for (e.g. GDP, employment factors, etc.), say the "market" determines that the currencies are equal in value. So, if you wanted to buy US$ 1, you'd go to the bank and give them Cdn$ 1.

Now, suppose the Canadian government decides that they want their dollar to be worth less because, for example, they think this will stimulate exports. How do they do that? Answer: they just put a lot more currency into circulation. They do this by "starting up the printing press." Suddenly, there are $ 150 Canadian dollars in circulation. Unless something drastic has changed in the economies of Canada and the US, you don't have to be a brain surgeon to see that a US dollar is now worth 1.5 times as much as a Canadian. So the value of a US dollar is now worth Cdn$ 1.50, or, said differently,.the Canadian dollar is now valued at (1 / 1.50 =) about 67 cents US.

Sterilization

A second, albeit less common, method to accomplish this is known as "sterilization". In this case, Canada would buy US dollars and take them out of circulation (e.g. by buying US Treasuries.) In so doing, Canada has "sterilized" the US dollar, leaving the same number of Canadian dollars in circulation but taking the number of US dollars out of the system. The fewer US dollars in circulation compared to the number of Canadian dollars, the less the supply of US currency vis a vis the Canadian, and the more valuable the US dollar becomes.

Essentially, this is what China is doing to the US dollar now - and one of the reasons the US dollar hasn't completely collapsed under the weight of Obama's spending programs. By buying US treasuries with its "excess" US funds, it is effectively forcing "the Fed" to take those dollars out of circulation in exchange for debt, thus reducing the number of US dollars in circulation and propping up its value. Moreover, because there are trillions of dollars involved, this also has the effect of lowering the value of other currencies worldwide. (Yes, it's more complex than that, but you see the point.) The situation for China is exactly the opposite - by buying US Treasuries, they are lifting the value of the US dollar (by reducing the supply) and "depressing" the value of the Yuan (by keeping the number of Yuan constant.) Again, the "Law of Supply and Demand".

At the same time, you see why "the Fed" is buying US Treasuries. Here, it is taking the amount of debt out and replacing it with money for "Washington" to spend. (Sorry, Mr. President. I meant to say "invest". Sure.) Remember, both currency and Treasuries are debts of the US government so this is an exchange of one government liability for another.

Interest Rates

This is simple. Suppose Bill Gates wants you to lend him $1 million. How much interest will you charge him? Say 5% p.a. Now, suppose Warren Buffett wants to borrow $ 1 million but he'll pay you 6%. I'm sure you'll agree that both are "first class" creditors. Who will you lend your money to? Buffett, of course. Why? Bigger return on investment for essentially the same risk. Right?

The same is true for governments. All things being equal (we're not comparing the US to Zimbabwe here), money will move to where it gets the "biggest bang for the buck" (pun intended!) But what happens when you do that? Essentially, you take those dollars out of circulation in exchange for the debt ... thereby reducing the supply of dollars in the system. The "Law of Supply and Demand" kicks in again and the value of the dollar goes up.

And if you're a foreign country doing that, say China, you'll be taking US dollars out of circulation while keeping the number of Yuan constant - the value of the Yuan goes down vis a vis the US dollar. So, if the US increases its interest rates, the Chinese can augment the value of the Yuan by not doing so. On the other hand, if they want to maintain a constant, or lower, exchange rate, they can do so by either increasing their interest rates accordingly ... or by buying US dollars and "sterilizing" them through the purchase of Treasuries.

Of course, it's more complex than this explanation because you're dealing with national economies of scale and there are "other factors" such as those I've cited, but this is a "primer" on how it works.