In a world where economies have become interdependent, nations have been forced to put in place measures that will help to stabilize and safeguard their economies from international disruptions that are common today. Among the many economic approaches that governments adopt in their quest for protecting domestic economies, monetary policy plays a critical role. According to Gertler and Karadi (2011), monetary policy is an important aspect of a given country’s economy since it increases the growth rate of an economy while at the same time helping to establish a balance of payment. Besides, it not only increases credit availability, but also controls inflation. As the paper reveals, besides promoting economic development, monetary policy helps to achieve equilibrium in the balance of payments in international trade.
Net Balance of Payment
Firstly, a country’s net balance of payment has a significant impact on the relative exchange rate for the given country’s currency (Hogan, 2012). By definition, the net balance of payment refers to the sum of the current account balance and the trade account balance. On the other hand, exchange rate refers to the price of a country’s currency in terms of an overseas country’s legal tender. The value of a country’s coinage is determined by many factors. The net balance of payments is one of the most important determinants. According to Mishra, Montiel, and Spilimbergo (2012), in the balance of payment, if a country’s exports rise at a higher rate relative to the imports, the terms of trade of the country are improved. The above situation leads to better terms of trade and a superior net balance of payment due to the augmented demand for exports. Amplified need for the country’s exports leads to more demand for its currency. The situation strengthens the currency’s value against other monies of the world. On the other hand, when a country’s export loses value, the balance of payment is unfavorably influenced. Such a situation has a negative impact on a country’s exchange rate. Adrian and Shin (2008) assert that a lower value of exports as compared to imports means that the country will spend more than it is earning from the international trade. Such a state of affairs means that the country will demand more of foreign currency to participate effectively in the international trade by purchasing imports (Adam, 2012). In the end, there will be less demand for domestic currency in the international market, and hence a loss of the value of the domestic currency.
Net Level of Interest
Governments use interest rates as an important monetary policy that helps a country in maintaining a balance of payment as it transacts with other international players. In this case, governments often increase or reduce the net interest rates on the current account balance of payments to achieve different results in the economy (Curdia & Woodford, 2010). The increase or reduction in the net interest rate has a profound impact on the country’s exchange rate. For instance, higher interest rates assist a country in reducing the inflation level, which makes exports more competitive and hence a positive influence the current account. Competitive exports lead to more demand for local currency, which improves the exchange rate for the domestic coinage against foreign currencies. Another impact of increased interest rate is that it makes imports more expensive while at the same time reducing domestic spending and hence fewer imports (Hogan, 2012). Such a move helps a country to have an improved current account whose impact on the exchange rate is as discussed above where it will be favorably affected. On the other hand, countries often reduce their interest rates when trying to inspire more trade between nations. With reduced interest rates, the country can devalue its currency. Although this process leads to more imports, it has both positive and negative consequences on the economy, as well as on the balance of payments (Gertler & Karadi, 2011). Consequently, depending on the intended outcome, a nation’s net level of interest level has both negative and positive impacts on its currency’s exchange in the international market. A high-interest fee leads to a higher trade price while an inferior rate leads to poor exchange rates. These business actions, which increase or decrease the exchange rate of a country’s current account, can lead to better or worse balance of payments, as well as to other positive and negative consequences that the country wants or does not wish to achieve through its actions.
The Nominal Inflation Rate
The other important factor that affects the exchange rate of a nation’s currency is the nominal inflation rate in the given country. In this case, nominal inflation rate is used to determine the real exchange rate of a given domestic currency in relation to overseas currencies (Adrian & Shin, 2008). Nominal inflation rate refers to the rate that has been calculated without considering other important aspects such as the declining balance of payments and other important factors in the economy. As a rule, although it has an impact on the economic status of a country, it is often ditched in favor of real price increments in determining the real exchange rate of a country’s coinage. However, it is often considered in trying to give a relative status of the state of an economy (Curdia & Woodford, 2010). A high nominal inflation rate has a negative impact on the country’s exchange rate, as the local currency loses value when it is compared to the foreign currencies. On the other hand, a lower nominal inflation rate may indicate a good economic performance and a higher value of the country’s currency in the foreign exchange market. However, in most cases, the real nominal is a better indicator of the real exchange rate for a country’s domestic currency.
Gross National Product
A country’s Gross National Product is a major aspect of its monetary policy. It acts as a key indicator of the country’s progress and wellbeing. Gross National Product refers to the total charge of all commodities and services that a country has produced in a given year through the labor and property that its citizens have supplied (Gertler & Karadi, 2011). In the international trade, a country’s GNP is a major factor in determining the country’s economic wellbeing in many ways. For instance, the products and services that the country produces determine the merchandise and services it will demand or offer in the international market (Adam, 2012). A higher GNP is an indicator of a country’s productivity. It has a positive impact on the economy. In this case, a country with a higher GNP means that it will demand fewer imports in terms of volume or value of imports into its domestic market. On other hand, a high GNP may also indicate a country’s favorable balance of payment. It may be in a better position to offer its surplus products to the international market (Hogan, 2012). Trade surplus has better outcomes for the country’s exchange rates, inflation, and economic wellbeing. On the other hand, a lower GNP may indicate a country’s inability to meet its domestic demands, which lead to more imports. Such a situation further means that with more demand for imports, the exchange rate is likely to be affected due to the decreased demand for the local currency in the international market (Adrian & Shin, 2008). A lower GNP may indicate a trade deficit for the country since it leads to more imports than exports both quantitatively and in value. GNP often correlates with trade deficits of a given country. In other words, a less GNP often leads to trade deficit while a higher one leads to trade leftovers.
From these expositions, monetary policy encompasses different issues, which are important in determining a country’s economic wellbeing in the international market. Without such policies, countries can easily find themselves disadvantaged in the highly competitive international market. For instance, it is evident that the net balance of payments has a major impact on the exchange rate. Further, the nominal inflation rate is also a key determinant of the country’s economic wellbeing and its currency’s exchange rate. In addition, the net level of interest rate can have a positive or negative impact on the exchange rate. Lastly, the GNP is a key determinant of whether a country is in trade deficit or otherwise. As such, these important aspects of monetary policy are significant in guiding a nation’s economy in the globe.
Adam, A. (2012). New Approaches to Monetary Policy. Theoretical and Applied Economics, 2(567), 89-96.
Adrian, T., & Shin, S. (2008). Money, liquidity, and monetary policy. Web.
Curdia, V., & Woodford, M. (2010). Credit spreads and monetary policy. Journal of Money, Credit and Banking, 42(s1), 3-35.
Gertler, M., & Karadi, P. (2011). A model of unconventional monetary policy. Journal of monetary Economics, 58(1), 17-34.
Hogan, D. (2012). Monetary Policy-Conventional and Unconventional: Taming the financial crisis. Poznan University of Economics Review, 12(2), 7-18.
Mishra, P., Montiel, J., & Spilimbergo, A. (2012). Monetary Transmission in Low-Income Countries: Effectiveness and Policy Implications. IMF Economic Review, 60(2), 270-302.