Assume that exchange rates are flexible and that the future expected exchange rate in one year is not constant. Suppose that individuals now expect that the domestic central bank will pursue contractionary monetary policy in one year. This expected future monetary contraction will cause which of the following to occur?
A) The current nominal exchange rate will decrease.
B) The current nominal exchange rate will increase.
C) The current nominal exchange rate will not change.
D) The effects on the current nominal exchange rate are ambiguous.
E) The effects on the current nominal exchange rate depend on future current account balances.

Question

Quizplus · Accepted Answer

When individuals expect a domestic central bank to pursue contractionary monetary policy in the future, it typically leads to expectations of higher interest rates in the future. Higher future interest rates make the domestic currency more attractive to investors, as they anticipate higher returns on investments denominated in that currency. This increased demand for the domestic currency in anticipation of the policy leads to an appreciation of the currency now, hence the current nominal exchange rate increases.

Assume That Exchange Rates Are Flexible and That the Future