Using the flexibleprice monetary approach to the exchange ra

Using the flexible-price monetary approach to the exchange rate, explain briefly the effect of the following shocks on the equilibrium exchange rate:

(i) A reduction in the external interest rate that is expected to be temporary.

(ii) A permanent improvement in the productivity of the domestic economy caused by economic reforms.

Solution

Ans

I There will be temporary flight of capital, deficit in bop and exchange rate will rise temporarily

2 due to productivity improvements prices will fall increasing exports and decreasing imports. Consequently exchange rate will fall permanently