Monetary and fiscal policy are tools used to stabilize an economy. Expansionary is used to increase the money supply in the economy during a recession period while contractionary when the economy is under inflation hence reducing money supply in the economy. In expansionary fiscal policy, when government expenditure is increased, and taxes decreased, more money is made available to the people. Hence, they will demand more domestic goods, which will become more expensive; thus, cheaper import demand will rise, leading to a rise in demand for foreign currency, which decreases the exchange rates of a given foreign currency. Reducing government spending and raising taxes reduces the money supply in the economy. Hence, less funds will be available to individuals. This will result in a decline in demand, which makes exports cheaper and import expensive; thus, a foreign nation will demand the domestic currency for them to buy cheaper export; hence this increases the exchange rate for domestic currency.
Monetary policy involves alteration of the interest rate. Contractionary monetary policy involves a rise in rates of interest to discourage lending hence decreasing the money available in hand, making export cheaper, leading to higher domestic currency exchange rates. Also, a rise in rates of interest causes an outflow of foreign currency; hence the exchange rate of domestic currency decreases. This is also done when the federal reserve decides to sell securities through open market operation, increasing discount rates, and reserve requirement ratio (Miyamoto, Nguyen & Sheremirov, 2019). On the contrary, expansionary monetary policy is aimed to raise money supply through buying securities from the public and also reduce the discount rate to encourage borrowing loans. As a result, there will be more demand for goods and services making exports more expensive and import cheaper hence domestic currency exchange rate rises cause they are in demand to get more foreign currency to purchase imports.
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References
ALENGA, G. I. (2015). M. A RESEARCH PAPER (Doctoral dissertation, Department of Economics, University of Nairobi).
Miyamoto, W., Nguyen, T. L., & Sheremirov, V. (2019). The effects of government spending on real exchange rates: evidence from military spending panel data. Journal of International Economics , 116 , 144-157.
