Effects of Monetary Policy Shocks on Exchange Rates

Over the years, many have been disturbed with the question of how shocks or hiccups in the monetary policy of a country can have an impact on the value of its currency. Many financial analysts and economists have come up with varied arguments to support their claims on the subject. Keep reading to find out some of the arguments that most people have made regarding the impacts of monetary policy shocks on the exchange rates.

In international finance, the role played by monetary policy in detailing the dynamics and volatility of rates of exchange is a key theme. There are many approaches through which monetary policy shocks can be determined, however, the most common one that is often applied in a variety of economies is vector auto regression (VAR). However, it is still surrounded with several concerns.

According to most studies, there is evidence that monetary policy shocks can lead to the depreciation of exchange rates. The identification of shocks is varied but the above effect can be achieved through the assumption of a structural model. However, studies indicate that even without assuming the structural model, a similar conclusion can still be arrived at.

Other reports also indicate that when governments implement monetary policies that stipulate high interest rates, it is likely that currency values will collapse. When the exchange rate appreciates, the interest rates are likely to fall. This was evident during the Asian financial crisis.

Another study on the impacts of monetary policy hiccups on exchange rate points out that if the monetary policy is too rigid; it mitigates the fall of the exchange rate. A focus on developing economies in times of currency crisis illustrate that a tight monetary policy is inclined to a collapse in the exchange rate.  A tight or rigid monetary policy can be characterized by measuring the level of interest rates, except in cases of increased inflation rates.

When looking at the impacts of monetary policy shocks on exchange rates, it should be noted that they vary depending on the particular policy. For instance, there are revelations that when exchange rate pegs are abandoned, currencies have the ability to rapidly depreciate. This has occurred to many nations including Malaysia, Philippines, and Korea among others. The result was a higher inflation and economic recession. In response to the situation, the International Monetary Fund argued that monetary policy should be tightened to ensure stabilization of exchange rate and help in recovering economic activity. However, this is still subject of debate since some economists think otherwise.

In most occasions, it happens that monetary policies are tightened in the event that the exchange rate is experiencing strong downward pressure. However, they are later loosened when the pressure has been eliminated.

It is the choice of a government to either tighten or loosen its monetary policy in order to avert situations of financial crisis. However, the effects of monetary policy on exchange rates still remain a subject of discussion.

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