Suppose the UK has instituted an expansionary monetary policy to fight unemployment in the economy. The UK has a floating exchange rate.a. If the exchange rate value of the pound remains steady, what are the effects of easy money on British national product and income? What is the effect on the British unemployment rate? Explain.b. Following the monetary expansion, what is the likely pressure on the exchange-rate value of the pound? Explain.c. What are the implications of the change in the exchange-rate value of the pound for British national product and unemployment? Does the change in the exchange rate tend to reinforce or counteract the expansionary thrust of the British monetary policy? Explain.

Question

What will be an ideal response?

Answer 1

POSSIBLE RESPONSE:

a. If the exchange rate remains steady, the expansionary monetary policy decreases domestic interest rates, so borrowing and spending increase. As a result, the domestic product and income tend to increase, and the unemployment rate tends to decrease.

b. The decrease in interest rates in the UK encourages a capital outflow from the UK and, hence, its financial account tends to worsen. The increase in British domestic product and income increases imports. So, Britain's current account also tends to worsen. Thus, Britain's overall payments tend to go into deficit. Therefore, the pound is most likely to depreciate vis-à-vis other currencies in the foreign exchange market.

c.  As the pound depreciates, the UK tends to gain international price competitiveness. British net exports tend to rise. This reinforces the expansionary thrust of British monetary policy on domestic product and income. It also reinforces the downward pressure on the British unemployment rate.