Back To CourseEconomics 102: Macroeconomics
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Aaron has worked in the financial industry for 14 years and has Accounting & Economics degree and masters in Business Administration. He is an accredited wealth manager.
Many of us would agree that we want to live in a country that is competitive and has a good standard of living compared to other countries around us. Many of us would also probably like the option to buy relatively cheap foreign products for our everyday use. Most economists would also agree that one of the primary international goals of macroeconomic policy is to maintain the position of the U.S. as one of the leaders in the world economy.
But how does one measure all of this? That is where the debate begins. Some believe a balance of trade deficit or surplus is the key measurement. Other economists might argue that we should look at the value of the exchange rate. This lesson will focus on the exchange rate and how fiscal and monetary policies can affect it and the prices we pay for goods every day.
To review, an exchange rate is simply the rate at which one country's currency can be traded or exchanged for another country's currency. It determines how cheap or how expensive it is for you to buy goods, such as televisions, clothes, and tires for your car. A high exchange rate for the U.S. dollar makes foreign currencies cheaper, which lowers the price of imports. This means you can buy more electronics and other goods and services for every dollar you make!
A low exchange rate makes imports more expensive because your dollar won't buy as much foreign currency. Although this means you will spend more of your paycheck on normal everyday items, on the flip side, it encourages exports, which can cause a balance of trade surplus and help the economy grow.
Now that we have recapped a few of the basics, let's dive deeper into how fiscal and monetary policy affect the exchange rate.
Fiscal policy, which is the use of government spending or taxes to grow or slow down the economy, can affect the exchange rate in three different ways. It can affect exchange rates through income changes, price changes, and interest rates. Let's explore each now.
When the government lowers your taxes through fiscal policy, it puts more income in your pocket! This means more shopping and morning stops at the local coffee shop, usually resulting in overall increased demand for goods and services. This means more imports. You have more money; you want to spend it! The rise in imports results in U.S. citizens selling more dollars to buy foreign currencies to pay for those imported goods. This decreases the dollar exchange rate, ultimately leading to more expensive products in the future.
When the government wants to grow the economy, it is known as expansionary policy. To do this, the government can reduce taxes or spend more to stimulate the economy. When the government spends more or decides to cut your tax bill, this ultimately leads to increased demand, which pushes the overall price of goods and services higher.
As the prices of goods increases, this also makes exports of our goods to other countries more expensive and imports more attractive. This leads to higher demand for foreign currency to buy goods and lower demand for dollars to purchase U.S. goods. This lowers the exchange rate. Contractionary policy, which is characterized by a decrease in government spending or increases in taxes, has the opposite effect.
Now that we have seen how income and price levels can affect the exchange rates, let's see how interest rates work. When the government takes an expansionary fiscal approach and wants to increase its spending, it has to get that money from somewhere. To do that, it sells bonds, which raises the interest rates. This higher U.S. interest rate causes foreign dollars to flow into the United States because foreign investors are attracted to the higher interest rates, which give them a better return on their money. People are always looking for a good return on their money!
This increased flow of capital pushes up the U.S. exchange rate. On the contrary, contractionary fiscal policy leads to lower interest rates and more capital flowing out of the U.S. and pushes down the exchange rate.
Monetary policy, which is headed by the Federal Reserve and involves changing the money supply and credit availability to individuals can also affect the exchange rates. Similar to fiscal policy, it can affect the exchange rates through three paths: income, prices, and interest rates.
Monetary policy acts in much the same way as fiscal policy in relation to income. When the money supply rises or credit gets easier (for example, your ability to get a loan), the income in your pocket increases. As our pocketbooks get bigger, we spend more money on imports. As we sell dollars to buy foreign currencies so we can pay for those exciting new goods, this decreases the dollar exchange rate. On the other hand, contractionary monetary policy, which leads to lower money supply or tighter credit, causes U.S. income to fall. This leads to fewer imports, less demand for foreign currency, and a rising U.S. exchange rate.
When the Federal Reserve wants to expand the economy, it pumps more money into the economy. More money in the economy leads to higher demand for goods and services, which increases the prices you pay. Similar to the income path, this rise in prices makes exports more expensive and imports relatively cheaper. When imports become cheaper, we buy more imports! This increases our demand for foreign currencies to pay for these goods and pushes down the exchange rate.
Although the income and price path act very similar for both monetary and fiscal policy, the interest rate path is just the opposite when comparing the two. When interest rates are lowered through monetary policy to help boost the economy, this lowers the amount of capital that flows into the United States. Foreign investors can't earn a very good return. This decreases the demand for U.S. dollars and decreases the U.S. exchange rate.
On the other hand, contractionary monetary policy, or an increase in interest rates, would have the opposite effect. For example, if someone in China was only earning 2% on their money at home, but knew they could invest their money in financial instruments in the United States and earn 6% instead, this would push up the demand for dollars in the U.S. and increase the value of the dollar and the U.S. exchange rate.
In summary, in order to do business with other countries, we often have to change our currency into the form of currency that the foreign country uses. An exchange rate helps us do that and is what determines how much foreign currency might cost us if we were to exchange our dollars to buy imports or invest overseas. Both fiscal and monetary policy can each affect the exchange rates in three different ways. The three paths are through income changes, price changes, and interest rates.
When the government or Federal Reserve uses monetary or fiscal policy to expand the economy, this increases our income and our demand for imports, and ultimately lowers the exchange rate. Contractionary policies have the opposite effect.
Likewise, an expansionary approach to fiscal or monetary policy can result in an increase in demand for goods and services. This leads to higher prices domestically and relatively cheaper imports. All of this lowers the value of the dollar, or decreases the exchange rate, as more people exchange or demand foreign currencies to pay for goods.
Although the income and price paths act very similar for monetary and fiscal policy, the interest rate path acts differently depending on whether fiscal or monetary policy is used. When the government takes an expansionary fiscal approach, this increases interest rates because the government has to sell bonds to raise the money it wants to spend; in turn, this attracts foreign capital and the demand for dollars, and ultimately increases the exchange rate. On the other hand, when the Federal Reserve takes an expansionary monetary policy approach through lower interest rates, this incents money to flow out of the country, seeking better returns. This decreases the demand for dollars and decreases the exchange rate.
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Back To CourseEconomics 102: Macroeconomics
16 chapters | 137 lessons | 14 flashcard sets