Question

Consider the uncovered interest-parity condition (UIP) using nominal interest rates.

a. What happens to the exchange rate if the foreign country lowers its nominal interest rates through expansionary monetary policy? How would that be reflected in the UIP curve graphically? Assume that the economy has a flexible exchange rate.

b. What needs to happen if a country has a fixed exchange rate system and the foreign country lowers 1 its nominal interest rate through expansionary policy? (Note that a fixed exchange rate system implies that the nominal exchange rate is held constant and if credible, should also equal the expected exchange rate!) How would this be reflected graphically? Discuss the UIP curve alone, without using the IS-MP graph.

Answer 1

a) Expansionary monetary policy is when a central bank uses its tools to stimulate the economy. That increases the money supply, lowers interest rates, and increases aggregate demand. ... It lowers the value of the currency, thereby decreasing the exchange rate. It is the opposite of contractionary monetary policy.

Changes in the supply of or demand for a currency will cause that currency to appreciate or depreciate. The demand for a currency changes based on other countries' wanting to buy goods, services, or assets using that currency. The supply of a currency changes based on how much people using that currency want the goods, services, or assets in other countries.

A sterilized foreign exchange intervention will have no effect on GNP or the exchange rate, unless international investors adjust their expected future exchange rate in response.

b) A fixed, or pegged, rate is a rate the government (central bank) sets and maintains as the official exchange rate.

A set price will be determined against a major world currency (usually the U.S. dollar, but also other major currencies such as the euro, the yen, or a basket of currencies). In order to maintain the local exchange rate, the central bank buys and sells its own currency on the foreign exchange market in return for the currency to which it is pegged.

Currencies were linked to gold, meaning that the value of local currency was fixed at a set exchange rate to gold ounces.Currencies were linked to gold, meaning that the value of local currency was fixed at a set exchange rate to gold ounces.

It was agreed that currencies would once again be fixed, or pegged, but this time to the U.S. dollar.

If a country needed to readjust the value of its currency, it could approach the IMF to adjust the pegged value of its currency.

Fixed regimes, however, can often lead to severe financial crises, since a peg is difficult to maintain in long run.

Foreign investors do not face political risk i.e. the fear of nationalism of foreign assets, restric­tions of transfer of assets, risk of default by foreign governments.

Under these conditions and with perfect mobility of capital investors or foreign asset holders would try to invest in the asset in any country that yields the highest return.

Under the fixed ex­change rate regime, it follows that when capital mobility is perfect, interest rates in the home coun­try cannot deviate from those prevailing abroad. It is quite evident from above that with perfect mobility of capital, under fixed exchange rate regime, monetary policy in a small open economy is quite ineffective to influence the levels of national income (output) and employment.