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Sunday, 29 June 2014

Monetary approach and the exchange rate determination

 In an era of open economy and globalisation where exchange rate is considered as an instrument of currency valuation and relative prices. Usually exchange rate determination infers its implications on monetary policy of a country. People often presume that an increase in a country's money growth and liquidity  eventually lead to rise in the price level and depreciation in the exchange rate.

The subsequent results tend to push interest rates as well as high inflation or simply real interest rates. In a single line we can postulate that, interest rate affects the monetary policy of a country in a vivid manner. The impact of exchange rate over monetary policy depends upon  the openness of an economy.

Governments often control money supply to control inflation. The depreciation of US dollar in November 1978 government resorted to restrictive monetary policy to combat inflationary pressures. Contrary to this, when countries like France tried to intervene and regulate the exchange rate, inconsistencies with domestic policies noticed. But in the long run these inconsistencies have been countervailed by withdrawal from the governments on exchange rate and liquidity.

One should realise, that share of imports in the GDP is directly proportional to the exchange rate change. Governments should try to minimise imports in order to make monetary policy more effective. As imports and exports are more elastic with respect to the exchange rate, an stable exchange rate helps to increase the effectiveness of monetary policy.

In addition, more elastic private investment with respect to the interest rate lead to effective monetary policy and a relatively ineffective monetary policy. It is very clear that under flexible exchange rates the effectiveness monetary and fiscal policies relies on the share of import in the GDP, trade elasticity and liquidity of money.

Central banks can only control short-term interest rates. One of the key issues dominating the empirical literature is whether exchange rates can be predicted. Previous assessments of nominal exchange rate determination have focused on a narrow set of models typically of the 1970s vintage.
These forecasts are tied to the actual values of exchange rates in the long run, although in a large number of cases the elasticity of the forecasts with respect to the actual values is different from unity. Overall, we find that model/specification/currency combinations that work well in one period do not necessarily work well in another period.

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