Part 2: Monetary Policy under Alternative Exchange Rate Regimes

An exchange rate is the value of one country's currency in terms of another country's
currency. It represents the rate at which one currency can be exchanged for another. E.g The
rate at which Ksh. Is exchanged with USD = 1USD=140Ksh.
Exchange rates are critical for international trade, as they determine the relative value of
different currencies, which in turn affects the cost of imports and exports.

An exchange rate regime refers to the set of rules and policies that a country's central bank
or monetary authority follows to manage its exchange rate. Different countries adopt various
exchange rate regimes based on their economic objectives, market conditions, and policy
preferences.
It is a system that determines the exchange rate (value of domestic currency to foreign
currency).
Exchange Rate Regimes

a) Floating Exchage Rate

The exchange rate is determined by the market forces of supply and demand in the foreign
exchange market. For instance, U.S., Japan, European Union, Australia, and Sweden
currencies.
The exchange rate is determined by market forces of supply and demand without direct
intervention from the central bank.

Supply of Foreign Currencies Demand of foreign currencies

1. foreigners purchase countries
products (Kenyan Tea).
2. foreigners make investment in
domestic country (Kenya)
3. Borrowing by foreigners
1. We import goods from foreign
countries (eg. China)
2. We make investments abroad
3. Repayment of foreign debt

Monetary policy is more effective in an open economy with floating exchange rates than in a
closed economy for two reasons:
 the exchange rate freedom grants the economy monetary independence and allows the
authorities to choose the domestic inflation rate;
 the exchange rate movements have an impact on the real economy by changing the
international competitiveness of the country’s output.
b) Fixed/Pegged Exchage Rate

The value of the domestic currency is tied to the value of another currency (like the US
dollar) or a basket of currencies.
The central bank intervenes in the foreign exchange market to maintain the exchange rate
within a specified range.
For instance, 120Ksh pegged to 1USD

c) Managed or Dirty Float Exchange Rate Regime

The exchange rate is influenced by market forces, but the central bank occasionally
intervenes to stabilize or manage the rate.
The government sets a range between which the currency is allowed to play/float.
Interventions can be through buying or selling foreign currencies in the market. Many
countries adopt variations of this regime.

Part 3: Stabilization of Interest Rates and Exchange Rates

What is Stabilization Policy?

Stabilization policy is a strategy enacted by a government or its central bank that is aimed at
maintaining a healthy level of economic growth and minimal price changes.
It is a set of measures adopted by the government to stabilize the economy. It includes:

a) Interest rate stabilization

b) Exchange rate stabilization
c) Business cycle stabilization

The primary goal of stabilization policy is to smooth out the business cycle, which typically
includes periods of economic expansion and growth, as well as periods of recession and
contraction.
The interest rates, inflation and business cycles may be experiencing periods of ups and
down. These high fluctuations may negatively affect the optimal functioning of the economy.

The primary goal of stabilization policy is to maintain a stable economic environment. This
stability is essential for businesses to make investment decisions, consumers to plan their
spending, and financial markets to operate efficiently. Without stability, there can be wide
fluctuations in economic activity, leading to uncertainty and economic hardship.
Stabilization policies can take two main forms:

 Monetary Policy: Conducted by a country's central bank, monetary policy involves

actions such as adjusting interest rates, adjusting exchange rate, and controlling the
money supply to influence inflation, employment, and overall economic activity.

 Fiscal Policy: This involves government decisions related to taxation, government

spending, and budget deficits. During economic downturns, governments may
increase public spending and cut taxes to stimulate demand, while during economic
booms, they may reduce spending and increase taxes to prevent overheating.

Objectives of Stabilization Policy

Price Stability: One of the key goals is to control inflation and deflation, ensuring that the
general price level remains relatively stable. This is typically achieved through monetary
policy, which involves controlling the money supply and interest rates.
To control inflation and prevent deflation. Stable prices are essential for consumer and
business confidence, as well as for long-term planning and investment.
Economic Stability: Stabilization policies help maintain economic stability by reducing the
amplitude of economic cycles. By smoothing out fluctuations in economic activity, such as
recessions and booms, these policies help prevent extreme economic volatility, which can be
disruptive and harmful to businesses, individuals, and the overall economy.
Exchange Rate Stability: Stable exchange rates are important for international trade and
foreign investment. A volatile currency can make it difficult for businesses to plan and engage
in international transactions. Exchange rate stability can promote economic growth through
trade.
Economic Growth: By managing the business cycle and promoting a stable economic
environment, stabilization policies support long-term economic growth. Sustainable growth
can lead to higher living standards, increased job opportunities, and a rising standard of living
for the population.
Social Welfare: Economic stability and full employment reduce poverty and income
inequality, enhancing the overall well-being of a society. It can also lead to improved access
to social services, healthcare, and education, benefiting the most vulnerable members of the
population.

Stabilization of Interest Rates

Interest rate stabilization, also known as interest rate management, refers to the
implementation of policies and actions by a country's central bank or monetary authority to
achieve and maintain stability in interest rates within the financial system.
Interest rates play a crucial role in an economy, influencing borrowing costs, investment
decisions, savings behavior, and overall economic activity. Therefore, central banks often use
interest rate stabilization as a tool to achieve specific economic objectives.
Tools for Interest Rate Stabilization

a) Open Market Operations (OMO): Central banks buy or sell government securities to
influence the money supply, which, in turn, affects interest rates. Buying securities
injects money into the economy, lowering interest rates, and selling them removes
money, raising interest rates.
How it Works: When the central bank buys government securities, it injects money
into the banking system. This increased money supply leads to a surplus of funds, and
banks lower their interest rates to lend out the excess funds. Conversely, when the
central bank sells securities, it removes money from the system, leading to higher
interest rates as banks compete for scarcer funds.

b) Discount Rate: The central bank can change the discount rate at which commercial
banks borrow funds. Lowering the discount rate encourages banks to lend more,
reducing interest rates in the broader market.
How it Works: When the central bank lowers the discount rate, it becomes cheaper
for commercial banks to borrow money from central bank. This encourages banks to
lend more to consumers and businesses at lower interest rates. Conversely, raising the
discount rate makes borrowing more expensive, which can reduce lending and slow
down economic activity.

c) Reserve Requirements: Adjusting the required reserve ratios for commercial banks
can impact their lending capacity. Lower ratios free up more funds for lending,
reducing interest rates.
How it Works: Reducing reserve requirements means that banks can lend out a larger
proportion of their deposits, effectively increasing the money supply and lowering
interest rates. Raising reserve requirements has the opposite effect.

Exchange Rate Stabilization

Exchange rate stabilization is the process of implementing policies and actions to maintain a
relatively steady and predictable value of a country's currency in the foreign exchange
market.
It refers to the policies and measures employed by governments and central banks to maintain
a stable and predictable value of their national currency in relation to foreign currencies.

Stable exchange rates are important for various reasons, including promoting international
trade, attracting foreign investment, and reducing uncertainty for businesses and consumers.

Tools for Exchange Rate Stabilization

a) Fixed Exchange Rate System: In a fixed exchange rate system, a country pegs its
currency to another currency, a basket of currencies, or a commodity like gold. The
central bank intervenes in the foreign exchange market to maintain the fixed rate.
 How it Works: When the value of the national currency deviates from the fixed rate,
the central bank buys or sells its own currency to bring it back in line. This process
can require substantial foreign exchange reserves.

b) Managed Float Exchange Rate System: In this system, the exchange rate is allowed to
fluctuate within a predetermined range. However, the central bank may intervene in
the foreign exchange market to prevent the rate from going beyond the established
boundaries.
How it Works: When the exchange rate approaches the upper or lower limit, the
central bank intervenes by buying or selling its currency to maintain stability within
the range.

c) Foreign Exchange Reserves: Countries maintain foreign exchange reserves, usually in

the form of foreign currencies, to use for currency intervention. These reserves are
used to buy or sell the national currency in the foreign exchange market to stabilize its
value.
How it Works: When a country's currency is depreciating, the central bank can use its
foreign exchange reserves to buy its own currency, reducing the supply and thus
stabilizing the exchange rate. Conversely, when the currency is appreciating, the
central bank can sell its currency to increase supply.