Question

How would flexible exchange rates in the foreign exchange market impact fiscal and impact monetary policy?

Answer 1

Exchange rate is value of currency in terms of another:

The exchange rate is determined by following factors:

Foreign demand for a country’s exports, Domestic demand for imports, Relative interest rate changes, Relative rates of inflation, Investment from abroad.

There can be two scenarios possible:

Appreciation of currency or depreciation of currency. In appreciation domestic currency become expensive. eg: Earlier $1= 60 Rupees , now it is $1= 70 Rs. Dollar appreciated as it can buy more rupees now.

Depreciation of currency or depreciation of currency. In depreciation domestic currency become cheaper. eg: Earlier $1= 60 Rupees , now it is $1= 50 Rs. Dollar depreciated as it can buy less rupees now.

A country cannot afford if its currency value changes drastically. Fiscal and monetary policy are impacted by changes in currency value.

During appreciation of currency, a country can faces low inflation, high unemployment as import are higher but economy also grows due to more aggregate supply. Hence govt. changes fiscal policy to take benefit of this situation. If economic growth is achieved more then country can push for more spending and less taxes(expansionary fiscal policy) to get benefit of this situation.

Similarly when currency depreciates it can go for contractionary fiscal and monetary policy to attract more foreign currency.

Hence it is clear that changing currency rates makes govt and central bank to change fiscal and monetary policy respectively to ensure steady inflation, low unemployment and high growth rates are maintained.