Question

A country has had a steady value for its floating exchange rate (stated inversely as the domestic currency price of foreign currency) for a number of years. The country now tightens up on (reduces) its money supply dramatically. The country’s product price level is not immediately affected, but the price level gradually becomes lower (relative to what it otherwise would have been) during the next several years.

1. Why might the market exchange rate change a lot as this monetary tightening is announced and implemented?

2. What is the path of exchange rate likely to be over the next several years? Why?

Please try to make it 250 words if possible please. Thank you so much.

Answer 1

1. The nation’s interest rates witnesses a sudden increase due to the tightening of the money supply. Along with this, such kind of situation urges the investors to anticipate about the exchange rate value that their nation’s currency will supposedly rise in the near future. The background behind such kind of higher expectation for high exchange rate value is based on the fact that the price level of the nation will be lower and the currency itself will be relatively stronger. This is as per purchase price parity. Because of these reasons, demand for nation’s bound will rise as international investors will be inclined towards it. The reason behind the nation’s exchange rate value of the money to increase is the rise in demand for the nation’s currency in the spot exchange market. It is to be noted that the currency may witness rich appreciation because there is a chance that the current exchange rate might cross the range of its expected future spot value. It is because of the succeeding expected depreciation of the currency and high-interest rate, uncovered interest parity will be recreated.

2. f the other relevant factors are stable and firm, the domestic currency price of the foreign currency i.e. the exchange rate will supposedly fall quickly by a huge figure. Because of this, the exchange rate may increase with the span of time for its higher value which will be consistent with the purchase price parity.