Using the flexible-price monetary approach to the exchange rate, explain briefly

Question

Using the flexible-price monetary approach to the exchange rate, explain briefly the effect of the following shocks on the equilibrium exchange rate a. A permanent decrease in the demand for money triggered by domestic financial innovations. o. the future who would follow a more restrictive monetary policy than the current governor. c. A bond-financed fiscal expansion. d. A reduction in the external interest rate that is expected to be temporary. e A permanent improvement in the productivity of the domestic economy caused by economic reforms. The election of a conservative government likely to appoint a central bank governor in

Explanation / Answer

a. A permanent decrease in the demand for money will lead to an appreciation of domestic currency as against the foreign currency because a decreased demand by the domestic residence would mean the Central Bank will issue less domestic notes, and thus the less domestic currency will be available to the foreigners for their consumption of domestic products, thereby making the domestic currency more powerful as against the foreign currency.

b. A restrictive monetary policy would mean that lesser currency notes will be printed, which will make the domestic currency more powerful as against the foreign currency.

c. A bond-financed fiscal expansion will lead to an appreciation of foreign currency because when the govt. issues bonds, it essentially reduces the stock of money in the domestic economy. When the stock of domestic currency reduces in the economy, this makes the domestic currency "dearer" as against the foreign currency.

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