Economic Growth, Inflation, Interest and Exchange Rates

Economic Growth

Each nation’s government takes steps to help the economy achieve the goals of employment, stable prices, and growth. Monetary policy is one of the mechanisms a central bank uses to manipulate the entire level of economic growth by targeting money supply and interest rates.

In this regard, monetary policy can be depicted as accommodative if the interest rate is intended to create economic growth. If it is intended to combat growth (or, more often, combat inflation), it will raise interest rates to lower borrowing. These measures balance economic growth and maintain stable inflation.

Expansionary Money Policy and Its Effects

To counter a recession, central banks use expansionary policies. An expansionary policy aims at reducing interest rates and raising money supply. This increases the ease with which money is accessed because banks will be more willing to lend money. Interests are more attractive, and this encourages borrowers to borrow money and expand their businesses. Consequently, consumer demand rises.

Contractionary Money Policy and Its Effects

When the central bank believes that inflation is a problem, it will use a contractionary policy to counter the effects of inflation. A contractionary policy increases interest rates and reduces money supply. Borrowers then have to pay more for money borrowed while banks become more selective and cautious in giving out loans. This makes the acquisition of loans more difficult, and consequently, demand for goods and services decreases.

How Interest Rates Affect Exchange Rates

With all other factors held constant, high interest rates increase the value of a country’s currency and vice versa. Further, higher interest rates attract foreign investment, increasing demand for a country’s currency, while lower interests reduce foreign investment.

However, interest rates alone cannot determine the value of a currency; a country also needs to be economically and politically stable. These are some of the key factors investors consider when appraising the desirability of owning a given currency.

How Inflation Affects Exchange Rates

The inflation rate can also have a great effect on the value of a currency and the rates of exchange with other countries’ currencies. The effect is usually undesirable – a low inflation rate does not guarantee a suitable exchange rate for a country. In contrast, an extremely high inflation rate has a very high chance of affecting a country’s exchange rates negatively. That is why countries aim at equalizing inflation and interest rates for higher economic growth.

Question

A contractionary monetary policy will most likely have which of the following effects?

A. An increase in interest rates and a decrease in inflation

B. A decrease in interest rates and an increase in inflation

C. A decrease in interest rates and a decrease in inflation

Solution

The correct answer is A.

When a central bank believes that inflation is a problem, it will use a contractionary policy to counter the effects of inflation. A contractionary policy increases interest rates and reduces the money supply.

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Explain the relationships between monetary policy and economic growth, inflation, interest, and exchange rates