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What Is the Relationship between Monetary Policy and Exchange Rates?

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  • Written By: John Lister
  • Edited By: O. Wallace
  • Last Modified Date: 20 November 2016
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Monetary policy and exchange rates are closely related; exchange rates can affect both inflation and employment, which are two of the main targets of monetary policy. The decision to fix exchange rates, attempt to manage them, or leave them to float freely, is itself part of monetary policy. In principle, monetary policy is any decision that affects the availability and cost of money, both as cash and credit. It is the counterpart to fiscal policy, which involves public spending and taxation. The various elements of monetary policy and exchange rates have a symbiotic relationship, meaning each can affect the other or others.

Exchange rates can have a key effect on inflation. A low exchange rate means that imported goods become more expensive in the domestic currency. Depending on how much of a country's goods are imported rather than domestically produced, this can significantly increase inflationary pressures. This is more likely to have an effect in countries that lack natural resources and domestic production capacity, meaning consumers can't simply switch to a cheaper domestic supplier.

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Monetary policy and exchange rates are also connected in terms of employment. The same low exchange rate will make domestically produced goods cheaper to foreign buyers, which will in turn help domestic businesses receive more orders and need to take on staff. This is a good example of the difficulty of balancing different measures in monetary policy: the same low exchange rate has led to high employment, which is generally a positive, but high inflation, which is generally a negative.

There are widely varying levels of attempted control in monetary policy and exchange rates are no different. Some countries try to completely fix exchange rates, for example by placing legal restrictions on imports and exports and the movement of currency. Some countries let exchange rates float without any controls at all. Most lie somewhere in between, for example by having a policy of buying and selling currency to manipulate rates only in the event of rates reaching extreme levels.

Some other aspects of monetary policy can indirectly affect exchange rates. For example, if a country sets high bank base rates, commercial banks will be more likely to offer higher rates to savers, while businesses will need to offer higher rates to investors in corporate bonds. These high rates may attract investors from other countries, who will therefore need to exchange their own currency for that of the country they are investing in. This will increase demand for the currency, which will usually lead to a higher exchange rate.

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turquoise
Post 3

Exchange rates seem to be a measure of how strong an economy is. I constantly see people comparing the value of their national currency to other prominent currencies to rate their economy. If the exchange rate is in favor of the national currency, then the economy is said to be strong. For example, the US dollar, as of 2014, is a very strong currency in comparison to most other currencies. But it has less value than the Euro, so it is not as strong as it could be.

ZipLine
Post 2

@SarahGen-- That's a good question.

There are several indirect ways to impact exchange rates through monetary policy. Changing interest rates is one of the best ways to stabilize a currency.

In the example you gave, if the government increases interest rates, it can reduce money supply in the market, reduce inflation and increase the value of their currency. When interest rates go up, people borrow less money which reduces capital in the market. When there is less capital, the value of the national currency goes up.

The government can similarly increase the reserve requirement of banks to pull more of the national currency from the market. Or they could sell a little bit of their foreign currency

reserve. This will increase the foreign currency floating in the market and reduce the value of that currency in relation to the national currency.

These are basically methods that are utilized in a restrictive monetary policy. So this is the type of policy that government needs to pursue.

SarahGen
Post 1

If a country's national currency has low value in comparison to the US dollar. And if inflation rates, unemployment and prices have skyrocketed. What should that country do to fix the economy?

How can they increase the value of their national currency?

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