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Policy Effects with Exchange Rates Essay

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Policy Effects with Floating Exchange Rates

This chapter continues chapter nine’s discussion on the AA-DD model. It looks into the effects of the AA-DD model on an economy with a Floating Exchange Rate System. It also describes the government’s use of the model to formulate policies. It is evident that the AA-DD model affects a number of economic variables in the macro economy.

These variables include the GNP and the value of currency. Economists developed the above model to understand the connection between the various economic variables. The government affects some of these variables through expansionary policies and contractionary policies, among others. Therefore, this chapter looks at an Open Exchange Rate System and the effect of government policies on the AA-DD model.

The government uses two policies to control money supply in a country. That is, expansionary and contractionary policy with the effect of increasing and reducing money supply respectively. The effect of expansionary policy on the AA-DD model is a shift to the right. This increases the exchange rate of a country’s money with respect to another country. However, this does not happen fast. It takes on a transitional mode with many factors at play.

For example, the real money supply exceeds the real money demand. This, in the short run, means that inflation levels increase quickly. However, the trend lags as more people convert their money assets into non-money assets to beat or take advantage of the inflation levels. In the long term, the natural effect is that the exchange rate will increase with the amount of cash in the economy.

Governments employ the contractionary monetary policy when the money supply in an economy reduces. This reduction has the effect of shifting the AA-DD model downwards. When this happens, there is an immediate reduction in Gross National Product of a country. It also leads to a relatively stronger local currency.

Fiscal policy refers to government spending. The government is the biggest consumer and its consumption has many policy effects on the economy. The government uses this power to effect policies in a country through either reduction in spending (contractionary fiscal policy) or increase in spending (expansionary fiscal policy).

An increase in government spending causes AA-DD model to shift to the right. This causes a decrease in the exchange rate. For example, the Canadian dollar would do better than the American dollar in this situation. However, this leads to an increase in the GNP for the country. This is because it may attract more foreign investment as it is favorable to them. There are many causes for an expansionary policy. This includes transfer payments, tax reductions and government direct spending.

The three factors lead to different effects on the AA-DD model. The increase in government direct spending and tax reductions leads to increase in disposable incomes in a country, which causes increase in GNP. This increase leads to increase in GNP, which also increases real money demand. The effect is that interest rates increase. The reverse is true for contractionary fiscal policies, which occur because of limited government spending.

Government expansionary policy that occurs when the economy has numerous jobs spurs economic growth. This is because retailers and manufacturers enjoy better returns because of increased process of goods and services. Expansionary policy over a long period has some necessary effects to the economy.

The economy feels the heat as the increase in interest rates bites. However, the GNP does not increase immediately and before that happens, the government may plunge the economy into a placid situation. This is because lesser and lesser people will be willing to borrow.

Fixed Exchange Rates

They were once the only way to do business in the years before 1973. They are still in use albeit at a lower and managed level. There are various types of fixed rate exchange systems. In a fixed exchange rate system, the government determines the value of a country’s currency.

This is contrary to a floating exchange rate system in which the prevailing market conditions determine the rate of exchange. In a fixed exchange rate system, the government or the controlling authority has a lot of control on the value of a country’s currency. However, this is not the case in a floating exchange rate system (Suranovic 56).

There are various fixed exchange rate systems. The most common is the Gold Standard. In this system, which is the most common with people, Gold is used as the measure for exchange. Since it is considered to have an equal value world over, the exchange rate is fixed for particular amounts of gold. Price specie flow mechanism is the second one. It advocated for a reserve of gold whose value was known by all central banks that would have used the system.

This would maintain fairness and a particular standard. Other systems include the next one is crawling pegs where a country forecasts that during a particular period there will be volatility of its currency. Thus, it fixes the exchange rate for that particular period to eliminate problems with the economy. The most drastic method of fixing a currency is to use the currency of another country. For example, south Sudan may use the American dollar at a time when using the currency of another country is the best way to curb inflation.

In a fixed exchange rate system, it is evident that the country that uses it has to do something after a certain period to adjust the exchange rates. This means that the treasury or the government arm that deals with monetary and fiscal control has to be alert at all times to mitigate a possible problem. In a floating system, however, this is not the case since the system controls itself with up and down movements depending on demand and supply.

Hence, economists ask the question is it possible for the two systems to work well at the same time in a country. This is not entirely possible for a long time. It can only happen where the country wants to solve a particular problem. When the problem disappears, a country reverts to its earlier method. This is because the dynamics are too intricate and the formula and manner of doing it is too complicated.

From the above discussion, it evident that a country’s central bank can intervene to solve an economic problem using exchanges rate systems. They do this through a controlled environment where a country declares a particular amount of money to the reserve bank. This is to adjust the levels of a particular currency in the market in cases where it is in little or too much supply.

Hence, the central bank puts up Foreign Exchange Bureaus to buy or sell the currency in its residency. For example, the United States may put Foreign Exchange Bureaus that trade currency to sell British pound so that it can control its spread in the country.

This chapter looks at the balance of payments. For a country to be able to purchase foreign currency, it has to stock foreign currency in reserves in its country. These reserves are called the balance of payments reserve. Because of the frequent buying and selling of both foreign and domestic currency, these reserves may run low or increase.

When they run low, this is balance of payments deficit and when they are high, this is balance of payment surplus. These two are the indicators of the activity of the exchange rate and the government uses them as pointers.

In any market where there is trading in currency, the issue of black market trading is imminent. The players in this illegal market can be even the best financial operators in a country. This includes banks and other financial institutions.

Governments need to use so much resource to avoid this market since it has ability to cripple the financial system. The government also needs to ensure that the Foreign Exchange market is vibrant to eliminate a situation where there is undue demand or supply of one currency leading to a serene environment for black market trading.

Policy Effects with Fixed Exchange Rates

Governments do not work the same in either fixed or floating exchange rates. These policies shift depending on the type of exchange rate use. In this light, it important to know how the AA-DD model would behave in such situations. This means that a country should have a fixed exchange rate policy. This chapter is an analysis of the fixed exchange rate policy in light of the AA-DD model in situations of monetary policy and fiscal policy changes.

As seen earlier, the AA-DD model shifts according to changes in monetary policy. Under expansionary policy, the AA-DD model shifts to the right. The money supply puts pressure on the exchange rate. This cause significant reduction the interest rates, which arouses public interest to borrow more from among themselves and the government.

In that case, they sell their bonds and treasury shares. However, since the exchange rate is fixed, an automatic intervention form the government forestalls a situation where the rates overshadow its efforts. This is the effect in the short run.

When this happens for a long time, the government loses part of its GNP. This is the exact opposite when contractionary monetary policy is involved. Hence, governments that use fixed exchange rate systems need to strike a balance between quick short-term benefits or the long-term health of its economy in making policy decisions (Suranovic 67).

The government may also use expansionary fiscal policy or contractionary fiscal policy. In these two situations there are different after effects that play out. Fiscal policy emanates from the fact that the government is the major consumer in an economy. Another way to influence fiscal policy is through transfer of payments and tax revenues. Overall, expansionary fiscal policies increase the growth national product to a certain level. This happens in the short run in a situation where the exchange rate is fixed.

However, in the long term detrimental effects may play out in the economy. Contractionary fiscal policy causes the GNP to reduce significantly in the short run in a fixed exchange rate system. However, the long-term benefits outweigh the short-term results.

In a situation where there is an exchange rate policy with fixed exchange rates, the government uses the concept of devaluation and revaluation to affect the monetary policy. Devaluation refers to a situation where the government lowers the value of its currency through use the reserves reduction.

If the government increases the value of the reserve, it increases the value of its currency through a concept called revaluation. Generally, devaluation in a fixed exchange rate system causes a significant increase in GNP. Revaluation has an opposite effect and this happens in the short run. This is what the United States government accuses china of doing.

This part explains the reserve country and its effect on the reserve currency. For example, India may use the American dollar as its reserve currency and fix its exchange rate. By doing this, USA government has no authority to manipulate the Indian government in policy making just because it uses its money for reserve. It can use both expansionary and contractionary monetary policies to ensure the reserve fund is at its best.

To maintain sanity the country holding the reserve, the government needs to constantly buy and sell the reserve to respond to different market demands. Normally, a government holds the reserve in form of treasury bonds. This way it makes it easy to trade the bonds and hence control the market real time.

Failure to observe this may lead to a balance of payments crisis. Several things may lead to a balance of payments crisis. These crises may result from many things such as devaluations, capital flight, borrowing reserves, return to float among others.

Fixed vs. Floating Exchange Rates

The hardest question that governments and economist find is the determination between the fixed and the floating monetary policies. It is mind boggling to know which one to use. However, there is no definitive answer as all have worked and failed in different situations. For example, it is hard for a government to have the autonomy to control an economy in a fixed economy. However, it is easy to that in a floating economy.

Before choosing which system to adopt, a country must consider a number of factors. This includes its effect on the volatility of the risk involved, inflationary consequences and how autonomous the monetary system will be.

Exchange rate volatility refers to refs to what extent the value of exchange rate fluctuates over time. In essence, even from the wording, fixed exchange rate is not supposed to change at all. On the other hand, floating exchange rates are supposed to move up and down depending on the performance of the markets.

Hence, the more the changes in the value of exchange rate the more volatile it is. By definition, fixed exchange rates are not supposed to change. However, this is not necessarily the case as they are constantly revalued and devalued denoting changes. Exchange rate risk refers to the possibility that a person may lose money because of the changes in exchange rate (Suranovic 70).

Exchange rate risk is not unique to any particular person in an economy. Actually, it has the potential to have spiraling effects that span across the board. This is because it touches on various parts of the country’s economic system and particularly the import and export trade. This trade has a direct or an indirect influence on the prices of many commodities especially basic ones.

Exchange rate systems have inflationary effects too. When a government wants to adopt a particular exchange rate system, the best way is to adopt a system with the minimal inflationary tendencies. The writer notes that many governments world over have fallen prey to citizens demanding more spending from it and transfer of payments.

However, these governments do not increase taxes to cover these spending and transfers. This leads to huge public deficits, very high interest rates and inability to borrow money without significant harm to the economy (Suranovic 78).

In a floating exchange rate system, the options for the above situation are quite limited just as in the fixed system. This is because the short-term solution is normally to print money. This is not very popular as it the cause of many historically infamous situations. For example, the recent happenings in Zimbabwe and the Turkey situation in the 1980 etc. After departure from the fixed exchange rates system used in 1960 and 1970, the controls were chaotic.

This is because devaluation leads to automatic inflation. Additionally, the base currency in use, the dollar, sometimes experienced critical shortages because of unnecessary hoarding from some countries. Then, economists suggested the floating exchange rate where each country controlled its economy.

The problems it presented were numerous as the formulation of exchange rates to facilitate import and export trade came into being. Currencies were not steady anymore and some countries suffered because of runaway inflation. Currently, the return to the gold standard, used before the arrival of Bretton Woods’s institutions, are the ones frequently proposed.

The issue of monetary autonomy is back from history. In the past for decades and counting, the need to come together and have a single currency was not good. This was in the wake of a single fixed rate system, which led to a lot of chaos. Monetary autonomy refers to a country’s independency to make monetary decisions through its central bank.

This is true in a floating exchange rate system. It can increase money supply by lowering interest rates, which triggers borrowing, investment and economic growth. However, this is not possible in a fixed exchange rate system. In this system, different methods such as crawling peg. For effective central bank control of the monetary system, it has to have an independent way to operate separate from the government. This will avoid the situations in both Argentina and Zimbabwe.

The above discussion leads to the question, which is better between fixed and floating exchange rate systems. The fall of Bretton Woods meant that countries would formulate either their own monetary system or come together to have a bloc that had Base Exchange rate systems.

However, currently all countries look into options that best makes its economy more vibrant and stronger. For example, the Euro zone is currently engulfed in a monetary situation that is threatening its unity. Countries must formulate prudent and flawless monetary and fiscal policies if they are to survive the current turbulent times in the world economies.

Works Cited

Suranovic, Steven. International Finance, 2012. Web. <>

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