Relevance of Exchange Rates in Monetary Policy Making - Essay Example

Relevance of exchange rates in monetary policy making Introduction Monetary policy making is the act of any national monetary authority of a country to establish the size and rate of growth of money supply and, therefore, influence the interest rates in promoting a nation’s economic growth and stability. These actions may include increasing bank interest rates or decreasing the supply of money in the economy. The chief aims of such monetary policy are currency stability or price stability, achieving full employment and economic prosperity of a nation (Zettelmeyer & Zettelmeyer, 2003). Monetary policy rests on the correlation between interest rates of an economy and the total supply of money in the economy. It is natural that governments play a primary role in economic growth and stability through monetary policy especially in small rich economies. By creating monetary policies, central banks can influence the intensity of the supply of money on credit in the economy and, therefore, minimize extreme price fluctuations and improve economic growth. This control is made easier through clear knowledge of the monetary exchange rate that a country chooses to adopt (Jung, Choi & Jung, 2003). Relevance of exchange rates in monetary policy making Concisely, exchange rate refers to the rate at which one country’s money can be changed for another, that is, the price of one country’s currency in another country’s currency. Exchange rate is used when converting one currency to another or for engaging in foreign exchange market. The factors that influence exchange rates include political stability, inflation and interest rates. Nevertheless, exchange rate can, by itself, influence certain factors such as inflation and policy formulation and implementation (Ireland, 2008). For small economies and certain medium ones that are still very open to capital flows and trade, any changes in the value of exchange rate have a vital influence on the real economy or inflation. For successful pursuit of macro-economic stability and achievement of sustainable growth, prudent choices of exchange rate regime and appropriate policies are imperative (Ireland, 2008). The exchange rate and price stability of a nations monetary value define its economy. Iceland, for example, although is a small country, has enjoyed a long period of stability of economic prosperity with unemployment falling to near zero level. Iceland is an ideal and extreme example of a small open economy. Iceland has a population of 300,000 with a GDP of 8.5 billion USD. Like other economies, Iceland also faces trade and economic problems such as market fluctuations and terms of trade that makes it vulnerable. However, Iceland is endowed with a huge chunk of natural resources with a highly educated labor force and well established economic policies. The paramount indicator of stern overheating of an economy is inflation and Iceland picked it (Breedon, Petursson, & Rose, 2011). However, the key to controlling inflation is good management of the exchange rate and its coordination with fiscal policy (Jung, Choi & Jung, 2003). Several available models of exchange-rate determination entail an unambiguous effect of monetary policy. According to Argy, Grauwe and Polak (1990), this is explained in terms of money aggregates on the exchange rate where any increased rate of monetary growth in one country, against the surroundings of a stable claim for money tends to decline the nominal exchange rate. Most theoretical models predict that, in the end, an increase in one country’s money growth wholly reflects in the price level with the relative increment in the latter counteracted by depreciation of the exchange rate. When implementing a monetary policy care must be taken to ensure that the taxpayers do not lose much of their money (Zettelmeyer & Zettelmeyer, 2003). In the long run, countries with moderately rapid money expansion will lean towards having high nominal interest rates, as well as high inflation. However, in short run the interest rates changes viewed as consequences of monetary policy appear to have the convention-ally probable effect on exchange rates, at any rate in the huge national models (Breedon, Petursson, & Rose, 2011). An exogenous swell in nominal and by extension the real interest rate discrepancy is linked in the entire national models evaluated with differing levels of nominal exchange rate increment (Argy, Grauwe and Polak, 1990). However, any direct comparison between changes in interest rates and exchange rates may yield misleading results. This may occur when certain factors like expected inflation are exerting pressure on exchange rate and authorities or the central bank respond by adjusting interests rates but inadequately to offset other forces (Breedon, Petursson, & Rose, 2011). Through experience, there is no doubt that, if authorities or the central Bank take appropriate action, interest rate differentials assert themselves and get the expected effect on the exchange rate (Ireland, 2008). There is no doubt that changes in foreign policy have a large influence on exchange rates via their influences on interest rates and indirectly through their impact on comparative macroeconomic performance. In case of an increase in foreign capital outflow interest rates a downward exchange-rate pressure or an incipient capital outflow results. The proportion of these effects on the domestic economy largely depends on the realized degree of the downward pressure on exchange rate, which consequently inclines on the methodology of the set policy (Zettelmeyer & Zettelmeyer, 2003). Fiscal policies have effects on exchange rate with indeterminate theory and are not accommodated by monetary policy. The effects of fiscal policies rather present questions that can only be answered by certain key parameters. For example, in small economies like Ice Land, an increase in the deficit of the government budget is expected to raise the level of activity, money demand and interest rains in the short run. The intensity of the effect on interest rate also depends on the size of the spending multiplier and interest and income elasticity of demand and supply (Breedon, Petursson, & Rose, 2011). Any increase in interest rate will attract developing capital inflows and put upward pressure on the exchange rate (Jung, Choi & Jung, 2003). According to Zettelmeyer and Zettelmeyer (2003), fiscal policy is a supplement to interest rate and, therefore, it should be coordinated with monetary policy and the macro-prudential policy to ensure exchange rate stability and reinforce low inflation. For example, Iceland the macro prudential policy could have been applied to minimize the credit boom before the occurrence of the financial crisis. This would have helped to reduce the need to raise monetary policy rates in a bid to lower the inflation. In a similar way, a tighter fiscal policy would have reduced the need for application of higher policy rates (Argy, Grauwe and Polak, 1990). In such moments, if a small economy has stronger economic activity its current account will worsen and lead to an increased rate of inflation, consequently affecting the countries price performance in comparison to competitors. This, in turn, will extend the worse condition of the current account that could give rise to downward pressure on exchange rate that may adversely affect the expectations. This effect on exchange rate largely depends on the domestic substitutes, for the foreign goods, available within the country and the degree of flexibility of prices and wages (Zettelmeyer & Zettelmeyer, 2003). The exchange rate can influence inflation in two ways. First, it may have an immediate and direct impact on consumer price index (CPI) inflation since part of the goods getting into the CPI basket is imported. Secondly, exchange rate fluctuations effect CPI inflation through indirect channels, for example, depreciation of the local currency results to increased domestic production costs due to higher importation price of the intermediate goods, increased foreign demand for domestic goods and increased wage expectations (Breedon, Petursson, & Rose, 2011). Exchange rate is also a relevant factor in monetary policymaking due to its informative value. The exchange rate is an indicator in itself due to its forward-looking and directly observable nature. If a nation’s Central Bank is unable to observe their economic condition, it can use the nominal exchange rates for estimation (Jung, Choi & Jung, 2003). The interaction between exchange rates and macroeconomic policy depends on the existence of objectivity of the exchange rate itself. This existence varies across nations reflecting the degree of openness of economies. Some countries use the exchange rate to control their money supply hence control inflation. On the other hand, some countries have adopted exchange rate as an explicit policy target to help stabilize disparities in the economy (Zettelmeyer & Zettelmeyer, 2003). Flexible exchange rates, capital market liberalization, low inflation, or low exchange rates are never ends by themselves. They still leave economies vulnerable. Each economic policy has an objective to improve the economic welfare. People confuse means with ends. Macro-policy has one central task of maintaining high growth, full employment and stability. Hence, policy interventions should seek their basis of evaluation from this perspective. Important to note is that there are certain policies that maximize on exchange rates and employment but minimize on growth (Ireland, 2008). As noted in this paper, Exchange rate plays a vital role in decision-making. Important to note is that level of interests within a country still limited to the effect of inflation. While a central bank or an authority may target the exchange rate indirectly by settling on interest rate at levels consistent with the specified value of the exchange rate level. It is clear from previous studies that some interest rates do not respond to exchange rate fluctuations (Argy, Grauwe and Polak, 1990). Jung, Choi and Jung (2003) acknowledge that changes in monetary policy are able to affect expectations from returns. Iceland, for example, faces many problems like other small economies due to set monetary policies especially after the market liberalization. The country has a prudent fiscal policy but still has a very high account deficit balance. The presumption is that, like most other nations, this debt is not sustainable. However, within its small size Iceland can cope with debt and has even applied to get into the EU market. Equilibrium estimates of real exchange rate are usually very essential in conducting monetary policy under flexible exchange rates in supporting policymakers to evaluate the prevailing exchange rate and formulate judgments about its likely future direction. In case of a concern from an exchange rate, further analysis must be conducted to identify the underlying factors that drive the exchange rate (Jung, Choi & Jung, 2003). Conclusion According to Zettelmeyer and Zettelmeyer (2003), in line with this discussion, it is clear that the format of fixing a monetary policy into an exchange rate highly depends on a set context of each country, as well as the underlying shocks of an economy. An inflation targeting nation has a key dimension of this in the extent to which exchange rate fluctuations are transmitted in prices. Nevertheless, in the introduction of an appropriate monetary response it is essential to have full information on how the exchange rates that accompany a given movement influence the real economy. References Argy, V. E., Grauwe, P. D., & Polak, J. J. 1990. Choosing an exchange rate regime: the challenge for smaller industrial countries. Washington, D.C., International Monetary Fund. Breedon, F., Petursson, T. G., & Rose, A. K. (2011). Exchange Rate Policy in Small Rich Economies. Central Bank of Iceland Working Paper, (53), 1-39. Retrieved from http://www.sedlabanki.is/lisalib/getfile.aspx?itemid=8788 Jung, Y., Choi, W. G., & Jung, Y. 2003. Optimal Monetary Policy in a Small Open Economy with Habit Formation and Nominal Rigidities. Washington, D.C., International Monetary Fund. Ireland, Peter N. 2008 “Monetary Transmission Mechanism,” The New Palgrave Dictionary of Economics, 2nd ed., ed. by Steven N. Durlauf and Lawrence E. Blume (Houndmills, United Kingdom: Palgrave MacMillan). Zettelmeyer, J., & Zettelmeyer, J. 2003. The Impact of Monetary Policy on the Bilateral Exchange Rate Chile versus the United States. Washington, D.C., International Monetary Fund. Read More