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IAI Actuarial Core Principles · Business Economics · Role of money and interest rates in the economy

Which statement about the exchange-rate channel of monetary policy is correct for an open economy with free capital movement?

A rate rise attracts capital inflows and appreciates the currency, making exports dearer and imports cheaper, which lowers net exports and aggregate demand. This reinforces the contractionary effect of tighter policy. A rate cut works in the opposite direction, tending to depreciate the currency.

  1. AA rate rise tends to attract capital inflows, appreciate the currency, make exports dearer and imports cheaper, reducing aggregate demandCorrect
  2. BA rate rise tends to depreciate the currency and raise net exports
  3. CA rate cut tends to appreciate the currency and lower import prices
  4. DA rate cut reduces capital inflows and makes the currency stronger
  5. The exchange rate has no effect on aggregate demand through monetary policy

Explanation

Higher domestic interest rates raise returns on domestic assets, drawing foreign capital and appreciating the currency. Exports become more expensive abroad and imports cheaper, lowering net exports and aggregate demand, and also reducing imported inflation. The reverse holds for a rate cut.

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