When we suppose that, there are differences in interest rates between countries and prices are comparatively close then we expect exchange rates to change because of the BOP inequality. Interest rate parity supposes that the asset markets have more effect on exchange rates than the goods market…
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One of the shortcomings of an economy with a fixed exchange rate is that monetary policy cannot be utilized to stimulate the economy, although an economy with a floating exchange rate like the U.S. can employ monetary policy to stimulate economic growth.
The macroeconomic shock, interest rates in the domestic economy fluctuate with respect to foreign interest rates. For instance, when there is an expansionary monetary policy, it will cause interest rate to decline in the domestic economy, as a result, domestic investors will have an opportunity to invest in the foreign market that will cause a capital account deficit and cause the exchange rate to decrease. The monetary growth causes a raise in domestic income that in turn causes an increase in imports and a current account deficit. When the domestic money supply increases in the foreign market because of an increase in imports and net capital outflows, it leads to depreciation of the domestic currency due to the weak association between supply and demand. The decline in the exchange rate will cause domestic capital to be attractive for foreign investors and the domestic economy will start to draw foreign investment as the exchange rate declines until the BOP equals zero that lead to interest rate parity
. 1b The BOP factors that affect the supply for domestic currency in the foreign economies are a raise in imports and an increase in capital outflows in search of higher rates of return. These factors lead to a BOP deficit in the domestic economy and are frequently affected by expansionary monetary policy that causes a decrease in the domestic interest rate. 1C Increase in exports and an increase in capital inflows where foreign investors are in search of higher rates of return in the domestic economy are factors that affect the demand for domestic currency in the foreign economies. In addition, if the domestic economy cause an increase of exports, it indicate that domestic goods are relatively less expensive compared to foreign goods. Consequently, foreigners will demand more domestic currency as they import compared to domestic exports. When, the domestic rate of returns is more in respect to foreign economies, there will be a raise in demand for the domestic currency, as foreign investors will require domestic currency to buy domestic capital. 2A Based on flexible exchange rates and relatively responsive capital flows, we can establish that any fluctuate in the capital financial account will be greater in magnitude than fluctuate in the capital account. Thus, the EE curve will be flat compared to the LM curve. A fiscal expansion causes IS curve to shifts up and to the right that lead to increase of interest rates and output (y) .The increase in interest rates lead to increase of inflow of KA and a demand for domestic currency in magnitude than the CA deficit affected by increase in revenues that in turn increases imports relative to exports. This causes a BOP surplus that causes the exchange rate to appreciate and lead to shift of the EE curve up and to the left. The exchange rate will appreciate to the point where the BOP comes back to equilibrium. When exchange rate appreciates, the rate of return on domestic capital gets smaller due to diminishing marginal returns, which will reduce the rate of capital inflows to the domestic econ
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