Question on Monetary Policy


I could understand the logic behind this question’s answer. Can anybody please help.


Question : Which of the following is the most likely result of a central bank’s shift to an expansionary monetary policy?

A) Interest rates increase.

B) Domestic currency appreciates.

C) Exports increase.

Answer : C - Expansionary monetary policy decreases interest rates. This should cause the domestic currency to depreciate, which should increase foreign demand for the country’s exports.

According to me, the domestic currency should appreciate. If interest rate increases, it increases aggregate demand, investment, and appreciates currency.

They’re thinking about interest rate parity, which suggests that it will depreciate.

Putting some numbers to it:

Forward price of currency = Spot x (1+Rdomestic / 1+Rforeign). If both rates (domestic and foreign) were say 5% before, holding the foreign rate constant at 5% and decreasing the domestic rate (because of expansionary monetary policy) to say 2% will cause the currecy to depreciate - according to interest rate parity.

The depreciation of the currecy will cause exports to rise. A few hoops to jump through for that one…

SO can we say in a general way that in an expansionary monetary policy, govt. decreases interest rate, which therefore, depreciates currency?

Let’s see the mechanics behind the formula:

An expansionary monetary policy is driven by a reduction of the interest rate of the central bank which reduces the subsequent interest rates of the market until it arrives to the population and companies.

Population and companies have lower financing costs now, so they can consume and invest more. However, their savings are less attractive now because they pay lower interest rates. So we have two effects, the higher consumption / investment and lower savings.

An X% of the national savings will be liberated to be spent in more consumption and investment (" It’s time to consume and invest !! ") and Y% of the national savings will just go out from the country in search of higher interest rates. Since a good proportion of savings is in domestic currency they must be exchanged to foreign currency to go out the country so this increases the exchange rates (domestic currency depreciates and foreign currencies apreciate).

The exchange rates have increased. This is suitable for more exportations and less importations, so the GDP increases.

Remember the following:

  • Decrease in interest rates increases aggregate demand (AD) so the GDP level.

  • AD = C + I + G + (X - M), as we said, decrease in rates leads to higher C and I, so AD increases.


One thing that has helped me with the macro economics material is comparing it to what is going on in the world right now.

The Eurozone is aggressively adding stimulus (expansionary monetary policy) and thus decreasing the rates in the Eurozone. What has this done to the Euro/Dollar pair? It has helped the Dollar appreciate and the Euro depreciate. The ultimate goal in theory would then be to make Eurozone goods cheaper in the US and thus increase their exports to over here as the US will want to buy the cheaper goods.

I struggled with this stuff when I first read through the material but find a have a better grasp on the material now since I have started finding comaprisons to todays economic landscape.