Question

7. Now assume the country has a fixed exchange rate rather than a floating rate. a. Explain how the central bank could use a change in the exchange rate to stimulate the economy. Also, explain what monetary and fiscal policies you would use along with a change in the exchange rate. b. Now suppose the country has large debts in a foreign currency. Would this change your answer in (a)? Explain.

Answer 1

a) Under fixed exchange rate model, the central bank will initiate effective open market operation methods to stimulate the exchange rate. This can be done through expansionary monetary policy. The exchange rate will fall down with contractionary monetary policy. The falling exchange rate will depreciate the value of currency and attract foreign firms and enterprises to the domestic market. On the other hand, the expansionary fiscal policy will increase the government intervention to avoid the negative effects of inflation in the economy. The expansionary fiscal policy will cut the tax rates and raise the fiscal or government expenditure. The reduction in exchange rate will stimulate the economic activities and increase the level of production. The central government will introduce new securities in the open market and this will attract investors in the economy, thus the price of bond increased with respect to fall in interest rate. So the investment will exceed the saving rate.
b) If the country has huge debt over foreign currency; the falling exchange rate will be the most possible way. The reduction in the value of currency will attract more foreign money and high flow of foreign capital to the domestic economy. This will reduce the level of import which creates large debt over the domestic economy. Thus the falling exchange rate increase the level of export and increase the national income, which help to reduce the foreign debt of the economy.