Macroeconomics
Infow, Outfows, and Restrictions In times of inflation for example, central banks or the Fed can implement a contractionarymonetary policy to reduce aggregate demand and the demand for imports.Thisrequiresanincreaseininterest rates that results in the following chain of events: Interestrates↑→moneysupply↓→costofborrowing↑→consumption↓→aggregatedemand↓→ demand for imports ↓ → net exports ↑ → current account defcit ↓ However, this policy may not be effcient due to the following reasons: ➔ Higher interest rates (return on investment) attract foreign investments and promote capital inflows of hotmoney,whichisthecapitaltransferredbetweenfnancialinstitutionsinorderto increase interest or capital gain. ➔ Thisincreasesthedemandforthedomesticcurrencybecauseofincreasedforeigndemandfor domestic fnancial assets and investment. ➔ A currency appreciation may worsen the current account defcit instead of reducing it. The overall effect of this policy is indeterminate because it depends on whether the decrease in consumption is smaller or greater than the increase in the capital inflows caused by higher interest rates. Capital inflows and outflows in the loanable funds market are key factors in analyzing the effects of economic policies on the exchange rate. For instance, when capital inflows increase, the supply of loanable funds rises, leading to a drop in domestic real interest rates. This makes domesticfnancial assets less attractive to foreign investors, who then seek higher returns throughforeigninvestments. Consequently,thedemandforthedomesticcurrencydecreases,whileitssupplyincreasesasresidents exchange it for foreign currencies. Fiscal Policy Fiscalpolicytargetsaggregatedemandtocausechangesinthepriceandoutputlevelsinaneconomy. These changes also impact the exchange rate. For instance, the government might attempt to reduce a current account defcit on the balance of payments by increasing tax rates. This will result in the following chain of events. Income tax and/or corporate tax↑ → disposable incomes and/or investment ↓ → consumption ↓ → demand for imports ↓ → net exports ↑ → current account defcit ↓ Unlikemonetarypolicy,thispolicydoesnotaffecttheexchangeratenegativelybecausetheincreasein taxes allows the government to close defcits through higher government revenues. Supply-side fscal policies used to increase the competitiveness of domestic producers in order to stimulate exports result in an appreciation of the domestic currency. This is due to the fact that an
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