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Monetary and Supply-Side Policy: Question 4

Syllabus 4.3

Structured 10 marks

Kalenport is a small, open economy that trades heavily with the rest of the world. Its inflation rate has risen to 8%, well above the central bank's target of 2%, driven partly by strong consumer demand for imported goods. In response, the central bank raises its policy interest rate sharply. Higher returns attract foreign investors into Kalenport-currency assets, and the exchange rate, measured as the number of Kalenport dollars (K$) needed to buy one US dollar, falls from K$2.50 to K$2.00.

(a) Calculate the percentage change in the number of Kalenport dollars needed to buy one US dollar. [3]

(b) Explain how this change in the exchange rate is likely to affect Kalenport's inflation rate. [3]

(c) Explain one way in which this same change in the exchange rate could make it harder for Kalenport to achieve its balance of payments and economic growth aims. [4]

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Worked solution

Part (a): Calculating the percentage change in the exchange rate

The exchange rate (Kalenport dollars needed to buy one US dollar) falls from K$2.50 to K$2.00. Using the original rate as the base:

2.00−2.502.50×100=−0.502.50×100=−20%\frac{2.00 - 2.50}{2.50} \times 100 = \frac{-0.50}{2.50} \times 100 = -20\%

The number of Kalenport dollars needed to buy one US dollar has fallen by 20%\boxed{20\%}. Because fewer units of the domestic currency are now needed to buy a US dollar, the Kalenport dollar has appreciated (become stronger).

Part (b): Effect on Kalenport’s inflation rate

With the Kalenport dollar stronger, importers need fewer Kalenport dollars to buy the same quantity of foreign goods and raw materials. This means:

  • Imported consumer goods become cheaper in Kalenport-dollar terms.
  • Imported raw materials and components used by Kalenport firms also become cheaper, lowering firms’ costs.

Since imports made up a significant part of the demand driving Kalenport’s inflation, this fall in import prices eases overall price pressure, helping move the inflation rate down from 8% toward the central bank’s 2% target, supporting the goal behind the interest rate rise.

Part (c): A conflict with other macroeconomic aims

While a stronger currency helps control inflation, it makes life harder for Kalenport’s exporters. Foreign buyers now need more of their own currency to purchase Kalenport-dollar-priced exports, so those exports become less price-competitive in overseas markets. If this causes export sales to fall:

  • Kalenport’s earnings from exports decrease relative to what it spends on imports, which can worsen its balance of payments position.
  • Lower export sales mean lower output and income for Kalenport’s exporting industries, which can slow economic growth and put jobs in those industries at risk.

This illustrates a real trade-off: the same interest-rate rise and currency appreciation that helps meet the stable-prices aim can simultaneously work against the balance-of-payments-stability and economic-growth aims.

Final answers

  • (a) The exchange rate falls by 20%; this is an appreciation of the Kalenport dollar.
  • (b) Cheaper imports ease cost and price pressures, helping reduce inflation toward the target.
  • (c) Less competitive exports can reduce export sales, worsening the balance of payments and slowing economic growth.