International Economics Study Set 9
Quiz 23 :
Floating Exchange Rates and Internal Balance
The floating exchange rate is determined under the free market conditions by the forces of demand and supply and no government interference exists there. When a country allows the exchange rate to float then external balance can be easily achieved directly and at the same time it helps to achieve internal balance indirectly. The operation of fiscal policy in relation with the floating exchange rate is quite complicated. Fiscal policy has capacity to affect exchange rate in two directions. Hypothetically if the government decides to adopt expansionary fiscal policy i.e. enhance government spending for the unemployment reduction purpose, then how the exchange rate would be affected can be discussed through Figure 1. The fiscal expansion phenomenon results in interest rates rise in domestic country as the government meet this expenditure by borrowing more. Further higher domestic interest rates would attract foreign capital even temporarily. Simultaneously, aggregate expenditure, production volume, and income would be enhanced by increased government spending. Overall outcome would be more imports and worse off of the current account. As a final result, home currency would be appreciated firstly but later on it would gradually be depreciated. There are two opposite tendencies work for the home country's BOPs and finally for the exchange rate value of the home currency. Increased interest rate attracts capital inflow which actually strengthens home currency but increased aggregate demand as well as imports weakens it. Which of both of these outcomes relatively lasts long it is hard to express. If capital mobility globally is prevailing then the capital inflow outcome initially may be big so that home currency is appreciated. However, the aggregate demand outcome may be stronger and longer lasting so that the currency depreciates over time. The certain effects of external settlement brought under floating exchange rate regime on the home economy entirely depend on which direction the exchange rate varies. If home currency appreciates initially, then the country misses price competitiveness. The export volume declines and simultaneously imports rise. The deterioration of the country's current account can reduce the expansionary effects of the fiscal change i.e. increased government spending on the domestic output. It means that the expansionary effects can be reduced by global crowding out which basically imply that the appreciation of home currency and consequent decline of the current account.
The floating exchange rate is determined under the free market conditions by the forces of demand and supply and no government interference exists there. When a country allows the exchange rate to float then external balance can be easily achieved directly and at the same time it helps to achieve internal balance indirectly. In this situation, real domestic production and income increase to an unbelievable level beyond short run as monetary policy works effectively on economic forces. People tend to contract cashing holding in hand suddenly as expansionary monetary policy effect. Expansion of money supplied volume increases banks' lending capacity, and thus interest rates starts decreasing. Further, borrowing and spending activities increase. Decreased interest rates causes BOPs worsen in short run. The financial account starts worsening as capital out flows to abroad. Similarly, the current account also worsens as imports volume increase sharply. In this situation demand for forex exceeds its supply. Under floating exchange rate regime, this pressurizes to depreciate the exchange-rate value of home currency. Depreciation of home currency increases the global price rivalry of the products produced domestically. When the domestic firms gain ability to compete with foreign firms then current account would start improving since exports would exceed import. Thus initial contraction happened in the home economy would expand under floating exchange rate regime. This leads to appreciation of home currency and simultaneously expansion of real domestic production and income. Under floating exchange rate regime, change occurred to domestic production and income is far greater than it would be under fixed exchange rate regime. This is because in fixed exchange rate regime the government is supposed to interfere to maintain the exchange rate value so that BOPs deficits are recovered. So, monetary policy has limited effects on increasing real domestic production and income. But interestingly, under floating exchange rate regime, free settlement of market forces as a result of expansionary monetary policy leaves huge impact on real domestic production and income.
The contractionary monetary policy is a very useful tool to curb inflation. It basically affects domestic production and income through collective contribution of production and consumption activities. Under floating exchange rate it becomes more effective to fix some economic uncertainties. When a government adopts contractionary monetary policy in order to curb inflation in the domestic economy it leaves adverse impact on real domestic production and income. Under floating exchange rate regime, hypothetically if B government follows this policy in inflation period then contraction of money supplied volume decreases banks' lending capacity, and thus interest rates starts increasing. Further, borrowing and spending activities decrease. Increased interest rates causes BOPs improve in short run. The financial account starts improving as capital inflows into home economy. Similarly, the current account also improves as exports volume increase sharply. In this situation forex supply is abundant. Under floating exchange rate regime, this pressurizes to appreciate the exchange-rate value of B pound. Appreciation of B pound would deteriorate current account gradually as over time imports would exceed exports. Thus this leads to depreciation of B pound and simultaneously contraction of B real domestic production and income. The overall effect of the contractionary monetary policy undertaken by the B government would decrease price level and ultimately inflation rate would be reduced. Under floating exchange rate regime, when B government adopts the contractionary monetary policy or tighter money then pressure is on to appreciate the exchange-rate value of B pound. This is because tighter money reduces production and consumption capacity of B people but increases interest rates which attracts foreign capital thus improves BOPs shortly. In this situation forex supply is abundant and so pressure is on to appreciate the exchange-rate value of B pound. When the exchange-rate value of B pound is appreciated the reverse effects of contractionary monetary policy would emerge. This situation would again lead to depreciation of B pound in short run and expansion of B real domestic production and income beyond short run. The result is again inflation goes up. This is the implication of the contractionary monetary policy or tighter money adopted by B government. The change occurred to the exchange-rate value of B pound would of course reinforce or counteract the contractionary thrust of monetary policy undertaken by the B government. This is because monetary policy is highly effective in influencing domestic production and income. If one form of monetary policy results in its respective outcome and produces some unwanted outcome too then counterpart form of monetary policy is the only effective tool to fix the required situation. It means if expansionary monetary policy of B government produces more inflation then contractionary monetary policy is useful to solve it.