2. Monetary Tightening a. Suppose the central bank surprises the financial marke

Question

2. Monetary Tightening a. Suppose the central bank surprises the financial market participants with a surprise monetary tightening (reduction in the money supply). Show in a diagram and explain the effect on the home exchange rate. You may consider this policy a temporary policy and consider the short-run effect. b. Now suppose that before any money tightening happens, news reports lead financial market participants to believe that the central bank will tighten monetary policy in the future. Based on your answer to part (a), what will happen to the expected exchange rate (i.e, the exchange rate expected on the date that the central bank tightens monetary policy)? Show in a diagram and explain the effect of this change in expectations on the current exchange rate. Realize that you are being asked about what happens to the exchange rate before the monetary tightening actually occurs.

Explanation / Answer

There are two pillars because it consists of economic and monetary analysis.The economic analysis especially suitable for detecting short to medium risk to price stability. The monetary analysis plays an prominent role in identifying inflationary trend over extended horizons.

The country's export will have become relatively cheaper and imports will be relatively more expensive.The effect of an expansionary monetary policy is to lower the exchange rate, weaken the financial account and strengthen the current account . As a result , the exchange rate of the domestic currency will decrease.

There are some challenges for monetary policy over a time, The first is on our mandate and monetary policy strategy . We are fully committed to our mandate , which is to safeguard price stability in the euro area. two pillar monetary policy strategy has served well, both with respect to internal decision making and in trms of external communications. The second one is about the ECB's monetary policy during financial crisis, it has taken forceful and timely action . It did not shy away from taking some highly unusual but appropriate measures with the aim of supporting banks in the fulfillment of their major role,which is to provide credit to the euro area economy. finally there is some something to learn from financial crisis. In the respect ,our monetary analysis has proven robust in difficult times.

There are several ways in which changes in interest rate influence aggregrate demand, output and prices. When the bank 's own base interest rate goes up, then comercial banks and building societies will typially increase how much they charge on loans and the interest that they offer on savings.This tends to discourage busines from taking out loans to finance investment and encourages the consumer to save rather than spend. Conversely , when the base rate falls, banks cut the markets rates offered on loans and savings.

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