How Monetary Policy Reaches the Exchange Rate

You’ll be able to

Trace an interest rate change through capital flows to the exchange rate
Explain why the exchange rate channel reinforces monetary policy
Compare the exchange rate effects of monetary and fiscal expansion

The channel most students omit

Expansionary monetary policy lowers the domestic interest rate. That makes domestic assets less attractive to foreign investors, so demand for the domestic currency falls and it depreciates. A weaker currency makes exports cheaper and imports dearer, so net exports rise — which shifts AD further right. So the exchange rate channel reinforces monetary policy, adding to the investment channel rather than opposing it.

The monetary chain, extended

MS ↑ → nominal rate ↓ → (a) investment ↑ and (b) capital outflow → currency depreciates → Xn ↑ → both raise AD

Two channels, same direction. This is why monetary policy is often described as more powerful in an open economy.

Fiscal policy pulls the other way

Expansionary fiscal policy raises the interest rate, which attracts foreign capital and appreciates the currency, so net exports fall. That partly cancels the stimulus. This is sometimes called international crowding out — a second offset alongside the domestic investment crowding out from Unit 5. So the open economy makes monetary policy stronger and fiscal policy weaker, which is a genuinely useful comparison to be able to state.

What the exam expects you to hold constant

These traces assume the foreign interest rate is unchanged and capital moves freely. What matters is the interest rate differential, not the domestic rate alone: if both countries cut rates equally, capital has no reason to move and the exchange rate need not change. Questions specify one country acting precisely so the differential moves, and reading for that is what keeps the direction right.

Worked example

Compare the exchange rate and net export effects of expansionary monetary policy against expansionary fiscal policy, holding the foreign interest rate constant.

1.Monetary expansion lowers the domestic rate; capital flows out; currency depreciates; net exports rise.
2.That rise in Xn adds to the AD increase already coming from higher investment.
3.Fiscal expansion raises the domestic rate; capital flows in; currency appreciates; net exports fall.
4.That fall in Xn subtracts from the AD increase from higher G.

Answer: Monetary expansion depreciates the currency and raises net exports, reinforcing the stimulus. Fiscal expansion appreciates the currency and lowers net exports, partly offsetting it. The open economy strengthens monetary policy and weakens fiscal policy.

Watch out

Get the direction of capital flow right and everything follows. Capital chases the higher return: a rate cut sends capital out and weakens the currency; a rate rise draws capital in and strengthens it. Reversing this reverses every subsequent answer.

Checkpoint

A central bank lowers its policy rate while foreign rates stay unchanged. The domestic currency will:

Checkpoint

International crowding out from expansionary fiscal policy operates because:

Checkpoint

Two countries cut their policy rates by exactly the same amount at the same time. The exchange rate between them:

On the exam

On a multi-part question, the forex step almost always comes after the interest rate step. Establish which way the rate moved first, then let capital flow toward the higher return — the exchange rate follows mechanically.

Answer the 3 checkpoints as you read.