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Floating Exchange Rates: Domestic and Foreign Impact

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Under floating rates, the economy is more vulnerable to shocks coming from the domestic money market. Why?

If the foreign inflation rate rises permanently, would one expect a floating exchange rate to insulate the domestic economy in the short run? What would happen in the long run?

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Solution Summary

This solution addresses the impact of a floating currency exchange regime on domestic economies as well as the impact of foreign inflation on domestic economies.

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Under floating rates, the economy is more vulnerable to shocks coming from the domestic money market. Why?

These two questions are essentially about the impact of the floating currency exchange rate system that is most widely used today, in which the relationship between two currencies is allowed to "float" or "flex" depending on market dynamics. However, the exchange rate is in fact an instrument by which to achieve EXTERNAL balance, rather than internal; and because domestic monetary policy exerts a strong influence on domestic product and income. This is one reason that a country that has adopted a floating rate is more vulnerable to shocks in the domestic money market rather than international money markets, since floating exchange rates tend to reduce the impact of international shocks ...

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