Rate on Monetary Policy In more than one way, the choice of an exchange rate program plays a crucial role in determining the choice of macroeconomic policy and especially for the small open economies. The decision on whether to have a fixed exchange rate or not aids in determining options for monetary policy and/or the ability to maintain open capital markets.
While this is the case, economists are still not in agreement over implications associated with fixed exchange rates. As a matter of fact, recent research is mixed on whether any economy that is outside the 4 or 5 largest has any monetary freedom. Some of the most notable effects of fixed exchange rates on monetary policy are as highlighted below.
Reduction of real interest rates
As the real interest rate is reduced, capital assets and domestic financial becomes less attractive simply because there is a low return rate. Foreigners reduce their position in real estate, stocks, domestic bonds and other kinds of assets. The financial account also deteriorates because foreigners hold few domestic assets. What is more, domestic investors will prefer t make their investments outside as they pursue high rates of return.
Domestic investment reduction
When there is a reduction in the domestic investment made by foreigners, the citizens of the country also decrease their demand for the currency of the nation and they increase demand for currency from foreign countries. As a result of this, the exchange rate tends to decline. Buy essays customized to your academic requirements.
When there is no government intervention, the current and financial account sums to zero. As a decline in the financial account is noted, the current account improves by an equal amount. In other terms, this means there will be an improvement in the balance of trade. The exports of the country will also become cheaper while the imports will become relatively expensive.
The effect of expansionary monetary policy is lowering of the exchange rate, weakening of the financial account and the strengthening of the current account. When there is a restrictive monetary policy, the opposite is expected.
Increase of domestic GDP
The rise of domestic GDP will lead to an increase in demand for imports and this will cause deterioration of the current account. Also, because of the increase in imports purchases, there will also be the need to convert domestic currency into foreign currency and when there is no intervention from the government, the financial account moves upward to record a surplus while the current account sums to zero.
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