Have you ever wondered how the exchange rate between two currencies is determined? Ever lost your sleep over the effects on interest rates due to rising inflation? Or better still and closely related on the lines of Global Financial Crisis, how does a government keep the economy buoyant when everything seems to going south? Well, if you have pondered over these questions in the past, then you are reading the wrong article as I am not going to teach you all that. Please find the correct link in the footnotes that will answer all your questions. Thanks for your time.
But just before I end this article, let me touch upon a few intriguing facts which might just instigate you or raise your curiosity to completely understand the nitty gritty of economics. I do not intend to make it a boring topic for the readers; the only motive to write about this topic is to introduce people to the importance of basics of economics in everyday life. I pledge to explain things to the best of my ability and keep them as simple as I can.
Monetary Policy in the times of Recession
The government’s role in keeping economy under control was never tested to this extent since The Great Depression in 1930s. With the breakdown of financial system, government had to pitch in with so called monetary policy. There are 2 effects of Expansionary Monetary policy – the primary effect is that the decrease in Interest Rates discourage people to keep their money with the bank and instead encourages them to spend, increasing the Consumption and Investment (2 main components of GDP).
The secondary effect can be explained as – the decrease in Interest Rates domestically forces people to invest in those economies which are paying higher Interest Rates, increasing the fund outflow. The fund outflow means that there is excessive supply of local currency in the market resulting in the depreciation (more supply than demand) of the local currency. The depreciation results in higher exports (exporter will get more local currency in exchange for his products) and lower imports, effectively increasing the Net Exports (third component of GDP). The Monetary Policy thus increases the Aggregate Demand.
Handling Rising Inflation
The rising inflation is controlled by increasing the Interest Rates. The higher Interest Rate means that people will be more inclined to deposit their money in the banks and hence removes the excess money floating in the market. The cut-off of money from the market reduces the demand of the products and helps bring the prices down.
Exchange Rate Determination
The determination of exchange rates between INR and AUD is neither achieved by analysing their respective stock exchanges (a misconception I had before I came across truth) nor it is possible to conclude that because AUD is appreciating/depreciating against the INR, then AUD is going to have same effects when compared to a USD. The exchange rate between two countries is determined completely on the basis of the unique features enjoyed between those two countries. In the long run, exchange rate is determined on these bases –
- Relative Price Level – Rising Inflation in India relative to Australia results in depreciation of Indian currency with respect to AUD.
- Relative Productivity Level – Increasing Productivity (amount of goods produced from each unit of labour input) levels in India when compared to Australia helps in the appreciation of INR with respect to AUD.
- Preference of foreign or local goods – If consumer in India starts to prefer Australian products over Indian products, INR depreciates.
- Trade Barriers – If India imposes tariffs on Australian products, the Australian products become expansive which reduces their demand and hence INR appreciates.
In the short run, the exchange rate between two countries is determined by –
- Relative Interest Rates – If Australian Interest Rate is at 3% and Indian Interest Rate is at 6%, Australian investor would want to invest in India, increasing the demand of INR. Conversely, Indian investors will demand less AUD. INR will appreciate.
- Expected change in Exchange Rate – If Australian investors expect that Indian currency will appreciate in the next 3 months, Australian investment in India increases, increasing the demand of INR and also the supply of AUD in Indian Market. Henceforth, INR will appreciate.
One of the core subjects in my Masters degree – Introduction to International Economics – turned out to be a blessing in disguise for me. I say that as a blessing because it opened up new “interest” (now interest has another meaning for me as well – an economic term) areas for me and it was a disguise as I might have never taken up that subject had it not been a core requirement for the course.
I am also providing a link below (an awesome video) for those readers who want to understand the exact process that took place behind the 2008 sub-prime mortgage crisis.