What is the effect on a country’s economy of an artificially low exchange rate? Of an artificially high exchange rate?

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What is the effect on a country’s economy of an artificially low exchange rate? Of an artificially high exchange rate?

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What is the effect on a country’s economy of an artificially low exchange rate? Of an artificially high exchange rate?

Explanation & AnswerSolution by a verified expert

Explanation

The central bank of the country has gold reserves as well as reserves of foreign currencies. Using these, it can buy or sell its own currencies in the open market. Thus, there is a change in the demand for the home currency in foreign exchange market. As this change is not due to trade or investment activities, it is termed as artificial demand.
 
When the central bank sells its own currency in the open market, it reduces the demand for the currency making it artificially weak. Artificially weak currency creates a situation of inflation in the country. A weak currency requires the importers to pay more for the foreign goods. This ultimately forces them to raise the prices of those goods in domestic markets. To matchup with the competition of the imported goods, local traders also raise the price of similar domestic goods. Thus, such higher prices lead to inflation. Moreover, to maintain a weaker home currency, the central bank is required to sell more currency in the open market to maintain a higher supply of currency. This becomes difficult in the long run. A weak currency promotes the country's exports as domestic goods are cheaper as compared to foreign markets. However in the long run, in order to provide fair competition to their domestic traders, the foreign countries may levy heavy tariffs on their home country's exports. Thus, maintaining a weaker currency for a substantial period is not beneficial for a country's economy.
 
On the other side, the central bank purchases its own currency in the open market to increase its demand and make it artificially stronger. A stronger currency helps to reduce the cost of imported goods, as less amount is to be paid for the same quantity of goods. However, exports of the country may decline as local goods become costly in foreign markets. In the long run, higher imports and comparatively lower exports may lead to a trade deficit. Also, to maintain higher demand for home currency, the central bank needs to constantly buy their own currency, which may delete their gold or foreign reserves in the long run.
 
Thus an artificially strong or weak currency is not beneficial for the country's economy in the long run.

Verified Answer

Artificially low exchange rate creates inflationary situations in the country and a higher artificial exchange rate puts the economy in a situation of trade deficit.

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