Question

How does monetary policy impact exchange rates?

Answer 1

The monetary policy is a major driver of the exchange rates. Monetary policy can be eased or tightened according to the need of the government to monitor its exchange rate policy.

Exchange rates are very highly correlated to monetary policies. Cutting of rates in the monetary policies would be the leading to depreciation in the domestic currency value.

Such as when the federal reserve cut the the interest rates in the United States through its monetary policy, the dollars which is the domestic currency of United States will be reacting negative to that and other currencies in comparison to dollar will appreciate and dollar will depreciate relative to other currency .

This phenomenon is generally interpreted in the way that when the central banks cut on the interest rates, it means that it is predicting a a weak demand scenario in the entire economy and through cutting of interest rate, it is stimulating the economy and providing support to to the overall economy hence the currency market would interpret that the economy is not in a good position, and since the domestic currency is a reflection of different events in the economy, it will struggle against other currencies. Similarly an increase in interest rates will be interpreted in a way that there is high level of demand in economy, and the central bank is trying to control the money flow in the economy through increase in interest rates and it would be bullish for the domestic currency and the dollars will gain steam in such scenarios.

So monetary policy is a major determinant of exchange rates for the short as well as long term.