Monetary Policy with Floating Exchange Rates

The AA-DD model is used to assess the outcomes of monetary and fiscal policies within the floating exchange rate system. Under this system, an expansionary monetary policy can augment the gross national product and devalue the domestic currency. Similarly, a contractionary monetary policy reduces the gross national product and increases the value of domestic currencies. An expansionary fiscal policy augments the gross national product and increases the value of domestic currencies. However, a contractionary fiscal policy does the opposite. It is worth mentioning that these effects take place in the short run. The central bank can use open market operations to control exchange rates as well as interest rates.

The expansionary monetary policy causes the gross national product to increase. Also, it reduces the value of the currency as well as expanding the CAB under a floating exchange rate system. However, a contractionary monetary policy reduces both the exchange rate and the gross national product. This means that the value of the currency increases, whereas the CAB decreases. Figure 1 depicts the long-run effect of an expansionary monetary policy.

As shown in the diagram, increasing the money supply causes the AA line to move upward (step 1). Given that the exchange rates change faster than the GNP, the economy will immediately shift to the A’A’ curve prior to any GNP adjustments. In other words, the initial change will be from ‘F” to ‘G.’ What is more. The exchange rate will shift from E1 to E2.

Consequently, the value of the dollar will decrease. There are two long-run outcomes of an expansionary monetary policy (under a floating exchange rate system). The first outcome is the currency devaluation, while the second effect is zero adjustments in the real gross national product.

The exchange rate (under a floating exchange rate system) is established when the market demand for currency balances with the market supply. Under this condition, the central bank remains a passive player with respect to the interest rate determination. However, some external players may compel the central bank to review the exchange rate under this system. Usually, the central bank may heed the call to intervene to soothe fluctuations in the exchange rate.

International investors may find it hard to make sound decisions when the exchange rate is fluctuating rapidly. When this happens, investors and merchants will reduce their international activities to avoid making losses on their investments. The central bank can also intervene to reduce deficits in the current account. A considerable increase in the exchange rate can cause the country’s current account deficits to increase. An increase in the value of the domestic currency will reduce the cost of imported products, thus encouraging imports.

On the other hand, locally produced goods will be somewhat costly to foreigners. This means that the volume of export will decrease. Consequently, the current account deficit is likely to increase if the domestic currency appreciates.

The central bank can employ direct and indirect methods to control exchange rates. The direct method entails purchasing/selling currency in Forex markets. The indirect method entails controlling the amount of money circulating in the economy. The central bank can also employ sterilized intervention to stimulate adjustments in the exchange rate while simultaneously keeping interest rates and money supply constant.

The central bank can achieve this by offsetting the direct intervention in the foreign exchange market. This move also entails balancing transactions in the stock market. Experiential studies have shown that sterilized interventions are relatively effective in controlling exchange rates. If the central bank adopts considerable interventions in the foreign exchange market, this will definitely alter the demand and supply of money and bring about swift adjustments to the exchange rate.

Expansionary Monetary Policy in the Long Run.
Figure 1: Expansionary Monetary Policy in the Long Run.
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