Which of the following policies help to raise interest rate unambiguously and thereby lead to appreciation of currency?
- (a)Expansionary fiscal and monetary policy
- (b)Contractionary fiscal and monetary policy
- (c)Contractionary fiscal policy and expansionary monetary policy
- (d)Contractionary monetary policy and expansionary fiscal policy
Correct — D, Contractionary monetary policy and expansionary fiscal policy. Trace what each arm does to the interest rate. Tightening money reduces the supply of credit and pushes the interest rate up. Loosening fiscal policy, by spending more or taxing less, raises incomes and government borrowing, and both increase the demand for loanable funds, which also pushes the interest rate up. The two arms therefore pull the same way, and only in this combination is the direction unambiguous. A higher domestic interest rate attracts foreign capital, and the inflow of capital raises demand for the currency, so it appreciates. The United States lived through exactly this in the early 1980s: the Federal Reserve under Paul Volcker held money tight while the first Reagan administration ran an expansionary budget, long-term interest rates rose, capital flowed in, and the dollar gained about half its value against the yen, the Deutsche Mark, the franc and the pound between 1980 and 1985.
- (a)Expansionary fiscal and monetary policy — The two arms conflict. Fiscal expansion pushes the interest rate up while monetary expansion pushes it down, so the net effect depends on which is stronger. Nothing unambiguous can be said, which is what the question rules out.
- (b)Contractionary fiscal and monetary policy — Conflicting again, in the other direction. Fiscal contraction reduces borrowing and lowers the interest rate while monetary contraction raises it, so the outcome is once more indeterminate.
- (c)Contractionary fiscal policy and expansionary monetary policy — Both arms push the interest rate down, so this combination is unambiguous but in the wrong direction. Lower rates encourage capital to leave, which weakens the currency rather than strengthening it.
In the open-economy framework used at this level, fiscal and monetary policy each move the interest rate, and the exchange rate follows the interest rate through capital flows. Government spending or tax cuts raise output and the demand for money, and the extra borrowing competes for savings, so fiscal expansion raises the interest rate. A central bank that shrinks the money supply raises it too. When a country's interest rate rises relative to the rest of the world, investors move funds in to earn the higher return; buying the currency to do so bids its value up. The reverse mix drives capital out and the currency down.
The word doing the work in the stem is 'unambiguously'. Three of the four mixes have something to be said for them, and two of those three leave the interest rate's direction genuinely undetermined because the arms pull against each other. Only when both arms push the same way can the direction be asserted without qualification, and of the two same-direction mixes only one pushes upward. Setting the four options out as a two-by-two table of fiscal against monetary makes this visible in a moment. Worth remembering that a strong currency has costs as well: the dollar's rise in the early 1980s hurt American exporters badly enough that the major economies negotiated the 1985 Plaza Accord to bring it back down.
- Expansionary fiscal policy raises the interest rate by increasing income, money demand and government borrowing.
- Contractionary monetary policy raises the interest rate by reducing the supply of money and credit.
- Only the mix of tight money with loose fiscal policy pushes the interest rate up from both sides, which is what makes the direction unambiguous.
- A higher domestic interest rate attracts capital inflows, raising demand for the currency and causing it to appreciate.
- Between 1980 and 1985 the US dollar appreciated by roughly 50 per cent against the yen, the Deutsche Mark, the franc and the pound under precisely this policy mix.
Lay the four mixes out as a table and only one row has both arrows pointing up.
- Treating any contractionary policy as automatically rate-raising, without separating the fiscal arm from the monetary one.
- Missing the word 'unambiguously', which is what eliminates the two conflicting mixes.
- Assuming a stronger currency is always good news; it makes exports dearer abroad.
As a policy-mix item like this one, as a which-way-does-the-rupee-move item after an interest-rate change, or as a statements item on appreciation and depreciation.
With reference to the Indian economy, consider the following statements: 1. An increase in Nominal Effective Exchange Rate (NEER) indicates the appreciation of rupee. 2. An increase in the Real Effective Exchange Rate (REER) indicates an improvement in trade competitiveness. 3. An increasing trend in domestic inflation relative to inflation in other countries is likely to cause an increasing divergence between NEER and REER. Which of the above statements are correct?
- (a) 1 and 2 only
- (b) 2 and 3 only
- (c) 1 and 3 only
- (d) 1, 2 and 3
Answer(c) 1 and 3 only
What appreciation actually means once it is measured. This item asks which policy mix drives the currency up; that one asks how a rise is read off the effective exchange-rate indices and why the nominal and real measures can diverge.
Which of the following is/are the effects of devaluation or depreciation of currency? 1. It leads to increase in imports and decrease in exports. 2. It leads to increase in exports and decrease in imports. 3. It leads to increase in domestic inflation. 4. It leads to decrease in domestic inflation. Select the correct answer using the code given below:
- (a) 1 and 3 only
- (b) 1 and 4 only
- (c) 2 and 3 only
- (d) 3 only
Answer(c) 2 and 3 only
The consequences of a currency moving the other way, asked in the second session of the same year. Reading a depreciation correctly — dearer imports, cheaper exports, more domestic inflation — is what makes the appreciation in this item worth caring about.
- practice — not a real PYQ
Other things being equal, a rise in domestic interest rates relative to interest rates abroad is most likely to
- (a)cause the domestic currency to depreciate
- (b)cause the domestic currency to appreciate
- (c)leave the exchange rate unchanged
- (d)reduce foreign portfolio investment
Answer(b) cause the domestic currency to appreciate — foreign investors buy the currency in order to earn the higher return, and that demand lifts its value.
- practice — not a real PYQ
Which one of the following is an instrument of contractionary monetary policy?
- (a)Reducing the cash reserve ratio
- (b)Raising the cash reserve ratio
- (c)Increasing government capital expenditure
- (d)Cutting income tax rates
Answer(b) Raising the cash reserve ratio — it locks up a larger share of bank deposits with the central bank and shrinks the credit banks can create.