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Impact of fiscal and monetary policies on the exchange rate

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How changes in fiscal and monetary policies affect the exchange rate.

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The solution explains the impact of fiscal and monetary policies on the exchange rate.

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How changes in fiscal and monetary policies affect the exchange rate?
Monetary policy works through changes in the money supply. Fiscal policy works through changes in government spending or taxes. An increase in money supply (i.e., expansionary monetary policy) lowers the home interest rate. As a result, the domestic currency depreciates. An increase in government spending, a cut in taxes, or some combination of the two (i.e. expansionary fiscal policy) raises output. The increase in output raises the transactions demand for real money holdings, which in turn increases the home interest rate. As a result, the domestic currency appreciates.

Monetary Policy is where the central bank of a country influences the money supply. Monetary policy primarily influences asset markets (Money market and Foreign Exchange market). An expansionary monetary policy means that the Central Bank has increased the money supply. An expansionary monetary policy leads to a decline in domestic interest rates. This is because interest rate is the price for using money. The more is the supply of money, the lesser is the price paid for using this money. As domestic interest rates ...

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