Question

Assume that Malaysia (Ringgit) and Singapore (Dollar) are trading partners. Let’s further assume country Malaysia has a zero trade account balance and the government implements an expansionary monetary policy. i) Draw a correctly labelled graph of the foreign exchange market for dollar and and explain the impact of the policy change on the price of dollar (ringgit/dollar) under the current exchange rate system. ii) Using the same graph, show and explain what would happen in a fixed exchange rate system.

Answer 1

a).

Consider the following fig here D1 be the demand for foreign exchange reserve and S1 be the supply of foreign reserve, => the initial exchange rate is E1.

Now, the expansionary fiscal policy increase the AD given the AS that increase the equilibrium output. So, as the domestic output increases that further increase the import. The increase in import increases the “demand for exchange reserve”. So, as the demand for foreign exchange reserve increases the equilibrium exchange also increases, => price of dollar increases.

So, under the flexible exchange rate system the expansionary fiscal policy increases the price of foreign currency.

b).

Under the fixed exchange rate regime the expansionary fiscal policy will increase the demand for foreign exchange reserve but the exchange rate will not increase. So, at the initial exchange rate E1 the demand exceed the supply of foreign exchange reserve implied BoP deficit.

So, under fixed exchange rate regime the expansionary fiscal policy causes Balance of Payment deficit.