Question

Suppose that real interest rate abroad is same as in domestic economy (note: domestic economy is a small open economy). However, the central bank of foreign country decides to conduct expansionary monetary policy to support the economy during the recession. Explain how this change would affect:

a) (5 points) the domestic real interest rate

b) (5 points) net capital outflow

c) (5 points) the real exchange rate

d) (5 points) net exports

Answer 1

a). Answer:

As per the question real interest rate abroad is same as in domestic economy and domestic economy is a small open economy.  However, the central bank of foreign country decides to conduct expansionary monetary policy to support the economy during the recession. Because of expansionary monetary policy central bank of foreign country will increase money supply that decrease the interest rate in foreign country. Now the interest rate of foreign country is lower than in domestic economy. Now flow of fund or cash flow of foreign funds increase in the domestic country to earn better return compare to foreign country. In this situation the demand of domestic currency increase that appreciate the domestic currency.

Exchange rate not directly affect the interest rate in a country. It is depend upon the current economic condition and future projection. The major macroeconomic factors that affect he interest rate are inflation, trade deficit, deficit of BOP, GDP growth rate etc. But as per the question domestic economy and domestic economy is a small open economy so, if country has negative trade balance of high trade deficit then here, country will decrease the interest rate to depreciate its currency to increase export. Because when currency become costly then its negatively affect export. Other side, may be country need of foreign currency to boost its economic development then country will not do it.

b). Answer:

Net capital outflow is difference between acquisition of foreign assets by residents and acquisition of foreign assets by foreign country. Here foreign country decides to conduct expansionary monetary policy to support the economy during the recession. So, interest rate will decrease in foreign country and other side economy is in a recession phase. Now flow of fund or cash flow of foreign funds increase in the domestic country to earn better return compare to foreign country. In situation, the net capital outflow for domestic country will be negative and positive for foreign country (## in respect of the both country only). Here, acquisition of foreign assets by foreign country it means foreign country will acquire more assets in domestic country.

c). Answer:

Real exchange rate is the exchange rate that compares the relative price of consumption baskets of two country.

Because of expansionary monetary policy central bank of foreign country will increase money supply that decrease the interest rate in foreign country. Now the interest rate of foreign country is lower than in domestic economy. Now flow of fund or cash flow of foreign funds increase in the domestic country to earn better return compare to foreign country. In this situation the demand of domestic currency increase that appreciate the domestic currency. So, the purchasing power of domestic currency will increased. Here i am taking about nominal exchange rate

But if we talk about the real exchange rate then its depends upon the type of cashflow. If cash flow is in the form of FDI or for long term then it positively affect the domestic economy and boost economic development and growth. Its increase aggregate demand and price level also. So, it will negatively affect the real exchange rate of domestic country.

Other side in foreign country currency will depreciate and price will also increase because of increasing money supply through expansionary monetary policy that will increase aggregate demand. That will decrease the purchasing power of its currency.

So, the effect on real exchange rate is depend upon different things like, type of capital flow, current economic condition, net cash-outflow etc.

d). Answer:

Net export = Total Export - Total Import. Because the domestic currency of domestic currency will appreciate so, it will negatively affect the export and other hand decreased the cost of import. We have discussed above the that  if cash flow is in the form of FDI or for long term then it positively affect the domestic economy and boost economic development and growth. Its increase aggregate demand and price level also other side short-term flow do not more positively affect the economy. Suppose net cash outflow is for long term and in the form of FDI then it will increase the productivity and efficiency of the economy that will boost export. But if is highly depend upon the import then increasing export capacity or amount will not more helpful to increase net export. So, its depends upon the current situation of the economy.