In the case where the CB lowers interest rate, capital will flow out, leading to downward pressure on the exchange rate, and ultimately forcing the CB to buy the currency in the FX market.
Why does CB have to support the currency? Wouldn’t a lower exchange rate help with exports and stimulate the economy?
Why does supporting the exchange rate reverse the expansionary policy? wouldn’t domestic firms be able to borrow at a lower rate, and increase production.
If a central bank wants to pursue expansionary monetary policy by reducing the interest rate, capital will flow out (in pursuit of higher rates elsewhere), putting downward pressure on the exchange rate, i.e., the country’s currency will face depreciation pressure, thus forcing the central bank to start buying its own currency to counter the currency depreciation. This in effect reverses the expansionary monetary policy
It does. In the long run, most of the time, when a currency depreciates, goods and services from that country gets cheaper. And, one year from the currency devaluation, stock index shows growth of up to 40%. But, it happens in the long run.
In the short run, currency depreciates and it gets difficult to pay debts. So, countries want to maintain the exchange rate and hence they buy back their currencies.
A bit late to the party but I want to help:
Your 1st question: sudden devaluation might make foreign debt expensive or make vitals imports (energy, key materials…) unaffordable.
Your 2nd question: once CB buying currency to defend FX rate, you are rolling back all the cheap money handed out during low rates. So it undoes the expansionary policy. Of course there is a limit: might deplete forex reserve in the process