When the domestic exchange rate (P) and foreign price level (PH) remain unchanged, the price level of domestic currency depreciates (E rises), making domestic goods cheaper than foreign goods, and the increase of exports leads to the increase of domestic demand (D) and output (Y).
If the exchange rate depreciates, from e0 to e 1, the demand will increase. In order to keep the balance of the commodity market, the output (y) must also be increased, and GNP will also be increased from Y0 to Y 1. Exchange rate appreciation will have the opposite result.
Let's look at the changes in foreign price levels (PH). If the PH value increases, domestic goods will be relatively cheap, which will stimulate exports and help improve the domestic GNP level. On the other hand, if the domestic price level (P) rises, the domestic commodity prices are relatively expensive, which is not good for exports, and the demand drops, and the economy may decline. Therefore, when the foreign price level (PH) rises, the domestic price level (P) falls, and the domestic currency depreciates, even if the exchange rate remains unchanged, it will stimulate the increase of GNP.
Now, let's analyze the equilibrium of the asset market. The balance of the asset market includes two conditions:
(1) foreign exchange market equilibrium: r = RH-(EEAE)/E, that is, the interest rate parity condition.
(2) money market equilibrium: ms/p = l (r, y), that is, money supply equals money demand.
When these two conditions are met at the same time, the asset market reaches equilibrium. With this equilibrium, we can analyze the influence of monetary policy and fiscal policy on exchange rate.
1. The influence of monetary policy on exchange rate
The main form of monetary policy is to change the money supply in the economic system. When the money supply changes, the interest rate will also change. As far as monetary policy is concerned, the change of money supply is the main one. Although people mainly decide their economic behavior according to interest rate, interest rate is only an intermediate variable in the analysis process. This shows that the increase of money supply will lead to currency depreciation.
Why will it lead to currency depreciation? The reason is interest rate. When GNP and price level (P) remain unchanged, that is, money demand remains unchanged, increasing money supply will cause interest rates to fall. From the interest rate parity theorem, we can know that the result of interest rate decline is the depreciation of local currency relative to foreign currency. Conversely, if the money supply decreases, the exchange rate will appreciate.
2. The influence of fiscal policy on exchange rate
The main form of fiscal policy is to change the level of government expenditure and tax revenue. Changes in tax revenue can be analyzed together with changes in government expenditure.
When government spending increases, the currency will appreciate, which is also because of interest rates. With the increase of government expenditure, the demand for money increases accordingly. If the money supply remains unchanged and the money demand increases, it can cause the interest rate to rise, that is, the exchange rate to appreciate.
In comparison, although expansionary fiscal and monetary policies can stimulate the economy and increase output. However, monetary policy and fiscal policy have different effects on the domestic currency: monetary expansion devalues the currency, while fiscal expansion makes the currency appreciate.