Posted: August 27th, 2022

Exchange Rate and Monetary Policy

Exchange Rate and Monetary Policy

If a country wants to peg its currency to the dollar while allowing for the free movement of capital, which policy or policies would be adequate to the task? Communicate the likely course of future monetary policy to the public, respond to a fiscal expansion by fully crowding out private investment, or increasing output at the cost of biased inflation?
The soft peg policy is feasible in this case where the country wants to peg its currency to the dollar. The policy will allow the free movement of capital such that these capital flows are able to react to changes in interest rates. This policy will allow the exchange rate to move up and down by a relatively minimal amount in the short run of a number of months or a year and also move by large amounts over time. Generally, the country will be in a position to maintain a soft peg, an independent monetary policy while avoiding the extreme short term fluctuations.
Following the soft peg policy, the likely course of future monetary policy to the public is the contractionary monetary policy. The country’s central bank could use the monetary policy for raising the interest rates which will increase demand and reduce supply of the currency in the foreign exchange markets. This would lead to appreciation. The excess supply of the country’s currency in the foreign exchange market will prompt the country’s central bank to use its foreign currency reserves which in this case -the dollar- to demand its own currency and hence lead to the appreciation of its exchange rate. In contractionary monetary policy, the opposite of the crowding out effect happens. This is because the policy allows increased private activity within the credit market. The policy entails a decrease in government borrowing such that more money is left for private investments (Ross, 2021). Less pressure is put on the interest rates leaving more room for the small borrowers. In the long run, less government spending leads to fewer taxes and a subsequent pool of available funds for the private markets. The contractionary fiscal policy actually brings forth the crowding in effect. In case there is an increase in output at the cost of biased inflation, it may cause labor to be relatively cheap such that the wages start to change slowly and the value of government debt would be reduced (Mathai, 2020). Nonetheless, the public will identify the inflation bias and increase further their expectations of price increases that make it challenting or policy makers to attain low inflation ever.

References
Exchange-rate policies | Macroeconomics. (n.d.). Retrieved from https://courses.lumenlearning.com/wm-macroeconomics/chapter/exchange-rate-policies/
Mathai, K. (2020, February 24). Finance & development. Retrieved from https://www.imf.org/external/pubs/ft/fandd/basics/monpol.htm
Ross, S. (2021). How does contractionary fiscal policy lead to the opposite of the crowding-out effect? Retrieved from https://www.investopedia.com/ask/answers/041015/how-does-contractionary-fiscal-policy-lead-opposite-crowding-out-effect.asp

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