Question

1. If your country is using flexible or floating exchange rate against USD:  Please draw a simple interest parity relationship for your country. And evaluate the graph and its potential consequences in economy.
2. If your country is using a fixed exchange rate regime against USD: Please explain how interest parity graph looks like? Please evaluate the policy changes in your country when FED changes its own monetary policy.
3. if your country is USA, then your foreign currency is EURO. You can also use EURO as foreign currency instead of USD as long as you explain why.

In order to draw interest parity, please use your own data. To create data you need to create a table for exchange rate and interest rate for some period of time. You can use days or year, it is up to you. Using years is a better option since interest rates do not change every day or every month. IF you are using years take the average values for interest rate and exchange rate. Another option is using a specific day in a year (Ii.e., JAN 1^st ) and taking the values in that day. Please provide that table in your assignment. (10 points)

The country is Saudi Arabia.

Answer 1

Monetary policy under floating exchange rate:

Expansion of monetary policy is quite effective. When there is expansion of monetary policy, money

supply will increase shifting the LM curve rightwards from LM to LM’ resulting in fall in exchange rate

from E to E’ and output increases from Y to Y’. Hence, monetary policy increases total output. To revive

the economy from recession under floating exchange rate, monetary policy expansion is helpful.

Fiscal policy under fixed exchange rate:

Under fixed exchange rate, expansion of fiscal policy is effective. It can take place through: decrease in taxes, increase in spending etc. with expansionary fiscal policy, IS curve shifts rightwards from IS to IS’ leading to increase in output and rise in exchange rate. But to keep the exchange rate fixed, central bank intervenes by increasing the money supply leading to shift the LM curve rightwards from LM to LM’. Exchange rate is again restored at previous level with increase in output further. To fight from recession under fixed exchange rate, fiscal policy expansion is helpful.