Monetary Policy and Exchange Rates

Please review the Forbes article Finally Adding Growth and comment on the following:

Explain how a decrease in quantitative easing will influence the exchange rates.

Analyze how the changes in the Fed's policy will influence each of the components of aggregate demand. Make sure to describe what will specifically happen to each of the components of aggregate demand.

Use this lecture and assigned reading to inform your post. Respond to at least two of your classmates' posts.

Lecture

We will learn about the fluctuations in the exchange rates. There are a few main exchange rates that we will be focusing on: flexible, fixed, and managed. The United States has a flexible exchange rate system, which adjusts based on the market conditions. China has a fixed exchange rate system, which is set at a particular rate. It is very important to understand the difference between these types of exchange rate systems to know how it will influence economic growth.

The purchasing power parity is a theory that is focused on the law of one price, which states that a good must sell for the same price regardless of where it is sold. The purchasing power parity was established to understand that changes in the exchange rate will be visible using this theory as the good will sell for the same price in any country that it is purchased. The Big Mac Index is well known for establishing how much a Big Mac will cost in any country that we can purchase it in.

We will also be reviewing the macro concepts of aggregate demand and supply analysis. Aggregate demand is derived from four components: consumption, investment, government, and net exports. The largest component is consumption, which is roughly 70% of all economic activity for the United States. Output will be determined by both the short and long run and it is based on changes in the inventory level. For example, if aggregate demand is greater than aggregate supply, this will cause a decrease in the inventory level. The reason why there is a decrease in the inventory level is that there is a higher demand than what is currently being produced, which causes the decrease in the inventory.

Another important concept we focus on this week is changes with the money supply. There can be two important changes to the money, either a temporary or permanent increase or decrease in the money supply. If there is a temporary increase in the money supply, it will cause a slight decrease in the interest rates and will indirectly affect the spending by consumers and businesses. Now, if there is a permanent increase in the money supply, consumers and businesses will make adjustments as they will understand that the money supply will be increased for an extended period of time, which will cause an increase in spending. This is brought about by the change in policy to a permanent increase in the money supply.

In the article from the Journal of Finance, we learn that liquidity in the foreign exchange market has had very little attention, surprising given the foreign exchange market is the world's largest financial market (Mancini, Ranaldo, & Wrampelmeyer, 2013). Then we learn in the article by Iglesias (2012) the role the foreign exchange market plays since it is comprised of seven international currency pairs and how volatile the currency pairs are in the market. The foreign exchange market is thus far more concentrated than the stock market exchange (Igelesias, 2012). Lastly, we learn in the article by Sun, Gan, and Hu (2012) about the effects of short term interest rates in China. The article used empirical testing and discusses the relationship between monetary aggregate and short run money market interest rates (Sun, Gan & Hu, 2010).

Forbes School of Business Faculty

References

Iglesias, E.M. (2012). An analysis of extreme movements of exchange rates of the main currencies traded in the foreign exchange market. Applied Economics, 44(34-36), 4631-4637.

Mancini, L., Ranaldo, A., & Wrampelmeyer, J. (2013). Liquidity in the foreign exchange market: Measurement, commonality, and risk premiums. Journal of Finance, 68(5), 1805-1841. doi:10.1111/jofi.12053

Sun, S., Gan, C., & Hu, B. (2010). The effects of short-term interest rates on output, price and exchange rates: Recent evidence from China. International Journal of Business and Finance Research, 4(1), 173-191.