Question

Part 3: What are the current external (foreign) conditions you think are relevant for deciding what to do with the monetary policy instrument? (Federal Reserve)

Answer 1

The major instruments used by Federal Reserve to influence the monetary policy are open market instruments, repo rate and reserve requirements for banks. However, the choice of which monetary policy instruments will be used by central bank depends upon following crucial foreign(external) factors:

• Exchange Rate: The exchange rate between two economies depend on the value of one currency in terms of other currency. It is affected by the interest rates prevailing in home and domestic country. Since setting the repo rate will affect the value of domestic currency in terms of foreign currency and the exchange rate; it is a crucial external condition for deciding which monetary policy instrument the Fed will choose.
• Inflation Rate in Foreign Markets: Higher the money supply in an economy, higher will be the demand for domestically produced as well as imported goods. This will influence the balance of payments of the home country. If the inflation rate is high in foreign country then the price of imports will also be high and this will influence the money required to buy the imported goods.
• Interest Rate in Foreign Markets: The differential between interest rates in foreign and home country decides the value of currency of home versus foreign country. As already discussed, this further affects the exchange rate. We already know from the first point that exchange rate is a major factor to be considered while deciding upon the monetary policy instrument. Hence, interest rate in foreign country is a important external factor under consideration while deciding which monetary policy instrument to be used.