Question

Explain why, in the absence of the time consistency problem, you might expect a central bank to be effective at holding the value of its domestic currency at an artificially low level for a sustained period but not at an artificially high level.

Answer 1

A) A central bank can effect demand of domestic currency in two ways

1) It can increase demand of domestic currency by selling foreign currency

2) It can decrease demand of domestic currency by buying foreign currency (ie selling domestic currency)

As the central bank can print as much as domestic currency it is more likely able to take point 2 than point 1 for long period of time. So a cental bank is more effective in holding domestic value at low level than high in a long period of time.

However it may lead to inflationary pressures ( especially in a long term)