Exchange rate is influenced by the interaction of both monetary and fiscal policies. Under its expansionary monetary policy when the central banks of a country lowers the interest rate, money supply increases. Consequently, there is an inflation. The exchange rate (external value) of the country’s currency will depreciate. Reverse effect takes place when the interest rate is rased under the contractionary policy.
Likewise, in an expansionary fiscal policy – lowering the taxes and increasing expenditure deficit budget government demand for money rises, interest rate rises, exchange rate appreciates.
When there is a contractionary fiscal policy – raising taxes and reducing government expenditures, ‘surplus budget’ – demand for money decreases, interest rates fall, rate of exchanger depreciates.
1. It follows that monetary and fiscal policy must be coordinated for an effective result,
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2. Expansionary Monetary Policy to be combined with contractionary fiscal policy, w’ exchange depreciation is desired.
3. Obviously, expansionary monetary policy is contradictory to the contractionary fiscal policy in this regard.
4. Contractionary monetary policy and expansionary fiscal policy are complementary effectuating an appreciation of the exchange rate.
5. Expansionary fiscal policy and expansionary monetary policy are contradictory for goal – appreciation of exchange rate.
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Appreciation of a currency’s external value is not necessarily good. Depreciation is not always bad. When there is a recession or crisis, interest rates may be lowered to arrest recession and effectuating quick revival of the economy. There may be exchange depreciation This is considered to be a favourable outcome to boost exports and increase the reserves, so that, later on the currency value is strengthened. However, when currency depreciation occurs on account of high inflation in the country, it is regarded as undesirable phenomenon.