Why is it a struggle to defend the strength of a currency?

[tanjm]

People do not buy your local ccy just because you are selling it. They buy your local ccy (assuming no capital controls which means most of Asia is out except for cases like Japan or Singapore) because they either want to invest in real or financial assets (such as bonds) or speculate (in which case, they'll eventually sell your local ccy).

All this talk about bank reserves etc is not terribly meaningful in this context.

[Spidey]

Strength of a currency is generally supported by an underlying increase in the overall productive capability of a country. Hence, printing more money is just like a share split, it lower a stock's price but not the stock's value. After printing, the currency rates may adjust to reflect the additional money supply, but the underlying factors will strengthen it again. For example, if government replace all our $1 dollar notes with $2.5 dollar note denomination, such that 1SGD=1MYR, does it mean that sing dollar is becomes now less valuable than ringgit?

[hyom]

I agree that in theory it should be a simple matter to print local paper to acquire international assets (gold, foreign exchange, food, energy).

But the consequences of local inflation have also been pointed out. So the trick is to acquire the assets without having the newly created money circulate in the economy. One way is to force the banks to hold more money in reserve - this prevents the banks from financing an asset boom. Raising interest rates can pre-empt an asset boom, but may also push the currency higher (which could allow the sale of yet more currency).

Raising interest rates in an overvalued local currency can create another risk as pointed out by freedom. Local borrowers may borrow in foreign currencies with lower interest rates without realizing the forex risk. When the local currency eventually corrects, this can lead to widespread bad debt throughout the economy (Read the Asian financial crisis).

Strength of a currency is generally supported by an underlying increase in the overall productive capability of a country. Hence, printing more money is just like a share split, it lower a stock's price but not the stock's value. After printing, the currency rates may adjust to reflect the additional money supply, but the underlying factors will strengthen it again. For example, if government replace all our $1 dollar notes with $2.5 dollar note denomination, such that 1SGD=1MYR, does it mean that sing dollar is becomes now less valuable than ringgit?

This is a good point not to lose sight of. Real engineering beats financial engineering anytime anywhere.

I thank all of you for the replies, though the good answers lead to more questions. How do Central bankers know how much money to pump into the monetary system? Too much -> inflation. Too little -> recession. What to do during periods of stagflation (inflation + recession at the same time)?

Relying on central bankers' judgment have problems of their own, particularly in democracies. Our natural instincts is to take measures that make ourselves well-liked. It is no surprise that Alan Greenspan prefers to be a market hero by lowering interest rates whenever the market needs saving but hesitate in raising interest rates whenever the market needs to be cooled. Does this imply that inflation in democratic countries with fiat currency has only one way to go -> up?

[freedom]

I did not study extensively about Greenspan's policies. But for Bernanke's policy, it is much easier to get out. What Fed did in QE1 & QE2 is to expand Fed's balance sheet and buy a lot of RMBS, agency debt, treasuries, etc. All these securities eventually will mature. As long as Fed does not continue to maintain its current expanded balance sheet by replacing matured securities with new securities, slowly, Fed's balance sheet will shrink (matured securities will be replaced by money to be cancelled). In the end, all the liquidity pumped by Fed in QE1 & QE2 will be withdrawn from the system.

once Fed does not buy any new treasuries with matured securities(a.k.a POMO, permanent open market operation), we will know the liquidity is being withdrawn from the market by Fed.

---

forgot to mention that the current POMO is to buy long dated US treasuries, which makes it very far from withdrawing liquidity from the market.