What effect will a combination of expansionary fiscal policy and contractionary monetary policy

What effect will a combination of expansionary fiscal policy...

Key Concepts

Policy Mix Effects

When expansionary fiscal policy is combined with contractionary monetary policy, the overall impact on the exchange rate becomes a result of conflicting pressures. The fiscal policy stimulus may boost economic activity and potentially push up interest rates, while the contractionary monetary policy directly raises interest rates and reduces money supply. The higher domestic interest rates that result from both policies tend to appreciate the domestic currency by attracting foreign investment, although the net effect depends on the relative strength of each policy component.

Exchange Rate

The exchange rate is the price at which one country's currency can be exchanged for another’s and is influenced by factors such as interest rates, inflation, and overall economic performance. Higher domestic interest rates typically attract foreign capital, increasing the demand for the domestic currency, and thereby causing the currency to appreciate.

Fiscal Policy

Fiscal policy involves government decisions on taxation and government spending to influence economic activity. Expansionary fiscal policy, which increases spending or decreases taxes, aims to stimulate demand and can lead to higher domestic output along with potential increases in interest rates if the spending increases demand for borrowed funds.

Monetary Policy

Monetary policy is conducted by a central bank to control the money supply and interest rates, affecting economic variables like inflation and output. Contractionary monetary policy reduces the money supply or raises interest rates to cool down an overheating economy, which can lead to reduced domestic liquidity and higher borrowing costs.

Transcript

00:01 Considering a contractionary monetary policy, we want to know what's going to happen to the exchange rate that exports aggregate demand and aggregate supply.

00:09 So starting with the exchange rate, i've drawn for us a brief graphical representation of this because i think that tends to be the easiest way to understand it.

00:17 So if we're looking at this contractionary monetary policy, let's start with the fact that in doing so, the federal reserve, we're thinking in terms of the united states, they're likely to increase the real interest rate.

00:34 As a result of them increasing this real interest rate, if we're looking at this foreign exchange market for u .s.

00:42 Dollars, the increase in the interest rate, it makes it more attractive for investors to invest in the united states because they have that heightened potential to earn, meaning that the demand for the u .s.

00:51 Dollar is going to increase.

00:52 You're going to see that curve shift to the right.

00:54 And as a result, we're also going to see the supply decrease because people want to hold on to this newfound valuable dollar, right? so as a result, we're seeing a new equilibrium.

01:04 We see that the price or otherwise this exchange rate has increased.

01:14 Now as for net exports, so because the exchange rate has increased like we just saw, it's going to cause our exports to decrease because all of a sudden it's more expensive to purchase the us dollar.

01:28 So people are going to be purchasing fewer us goods...

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