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Submitted by: Andrzej Kloc
Monetary policy affects the economy is mainly by regulating the money supply through: changing the rate at which central bank lends to commercial banks, the so-called change. reserve, ie the value of bank deposits kilent w that can not be used by the bank for lending and the sale and purchase of treasury bills.
Loosening of monetary policy means increasing the quantity of money in the banking system, in turn strengthening the policy leads to a reduction in the amount of money in the banking system and thus the economy as a whole. At first glance, looser monetary policy seems to favor the development of the economy. In the end, the more money the more you can trade, produce and invest. On the other hand, more money means more demand for goods, greater demand higher prices. Companies in general use a maximum production capacity to meet demand so they must invest. Investing involves risk and in some cases, companies do not invest. Increased demand, therefore the volume of production remains unchanged. It causes inflation, and thus the depreciation of money. Money becomes cheaper, imports become more expensive which leads to its reduction and improving the trade balance. Going forward, inflation forces the government to increase the base rate to get people to save (deposit becomes more favorable), and to reduce the demand for loans (credit becomes more expensive). The central bank tightens monetary policy, such as increasing the basic rate, thus increasing the profitability of bonds, it attracts foreign capital, which converts its currency into the currency of the native and the exchange rate gets stronger.
Despite the consistency of reasoning, knowledge of monetary policy is not sufficient to correctly predict exchange rates. The effects of increasing or decreasing interest rates are not necessarily always the same. For example, a country with a large deficit, will not be seen as a good place to invest, even if the interest rates are high, the currency may weaken.
The worse problems are expected if we analyze fiscal policy. It aims to influence the economy through taxes and government spending. As in the case of monetary policy we have to deal with two cases
Fiscal policy
– loosening reducing taxes and / or increasing government spending
– tightening of fiscal policy increasing taxes and / or decreasing government spending
And again, if the first amount of money in the economy increases, but the impact on exchange rates depend on whether the economy is open to foreign capital flows, or maybe closed. The increase in government spending for example, can cause a rise in domestic demand for it an increase in imports and a worsening trade balance, and finally drop in currency exchange rates. On the other hand, the increase in demand results in increased production and increase profitability, and thus may result in the inflow of foreign capital and thus increase foreign exchange currency against foreign currencies. Thus, depending on the which of these effects can be expected to outweigh the we observe decline or growth rate. In the liberal economies of the free flow of capital has the advantage of capital flows so often result in loosening of fiscal policy, strengthening the domestic currency.
As you can see the analysis of monetary or fiscal policy can help in predicting, but after opening the position to be closely monitoring other gauges that indicate the direction of change. Indeed it is impossible to completely rely on the general rules of classical economics.
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