Question

Assume that the central bank increases the ratio of reserve requirements ad decreases rate of interest. Discuss the possible effects of this policy on the current account deficit (CAD) and the exchange rate.

Answer 1

The lowering of interest rate will attract investment rate and economic development. Low levels of interest rate expand the credit rate. When there is low interest rate, it will cause to the fall in exchange rate. The domestic currency depreciates and the demand in foreign exchange market falls down. This makes import more expensive and export more competitive. Current account deficit measures the shortfall between money flowing in through exports and money flowing out on imports. It measures the gap between money received and sent out during trade. At lower interest rate the imports are more expensive, so the current account deficit increased. There is huge trade gap occurred due to the expensive import.

With increasing reserve ratio, the lending by the bank increases. This will provide huge amount of lending by the bank and the amount of money in the economy increased. At the same time there is low interest rate and no one wished to invest the money. The consumption increased and this leads to lowering exchange rate. Low level of exchange rate makes the less expensive exports. The values of domestic currency also fall down. There is no capital inflow and this dampens the foreign trade and relation. This affects the overall economic growth and output level.