The likely implications of a large country engaging in loose monetary Essay - 1

The likely implications of a large country engaging in loose monetary policy for exchange rates - Essay Example Like any other economy in the world, certain internal and external factors move its exchange rates in the short term and long term. These range from inflation and interests rates, balance of payment, investors and traders confidence in Germany and fiscal health of the government among others. Loose monetary policy generates both positive and negative effects to the economy, where the later can be severe and may require protection interventions to regulate the economic behaviour Monetary policies are controlled by the federal governments through the Central Banks in the nations. Therefore, depending on how the economy is performing, the federal government would provide the guidance on the monetary policy (loose or tight) to adopt. On the other hand, fiscal monetary policy in an economy and the transmission of a shock from the broader economy (e.g. global crisis or US shock affecting the Euro) could affect and action of the government and eventually the monetary policy. Large countries have high population of people and due to their engagement in economic development and high international transactions with the rest of the world; they tend to affect the economic variables of other open foreign markets, more than the small countries. Open economies/ countries are those that participate in international trade or economic activities, facilitating some level of freedom in importation and exportation with other countries. Measuring openness is quite complicated and theoretically determined by the level of protectionism (e.g. tariffs) applied by the country. However it can be estimated through the trade to GDP ratio in a country. Small countries are more open than large countries; they have higher than 70 percent openness premium (shares of imports and exports in GDP) (Damijan et al, 2013, p. 4). The effect of the loose monetary policy in the domestic front of small countries tends to be similar to large countries and perhaps faster and severely. However, in the foreig n front, there would be a variance, especially in the international factor flow that is translated in the domestic capital market. This is because of the trade volatility and high degree of openness that make them more vulnerable to external shocks. Similarly, the shocks from the small countries tend to have negligible effect in the broader foreign market, hence on the receivers end. What would happen to the exchange rates in Germany in case of a loose monetary policy? German is the largest economy in Europe with an open but regulated market. It also shares a common currency (Euro) with rest of the nations in the European Union who accepted to the terms of currency union. This in fact reduces the chances of speculative attacks on the Germany currency. According to the Europecafe (2013), German stood at number 5 rank of the largest economies across the globe; the dominating European country in trade and especially in machinery export abroad. If German can opt for an expansionary mone tary policy, its real interest rates would decline, forcing Germany’s domestic capital and financial assets to have lower real rates of return. The basic principal here is that monetary policy affects finances through interest rates and ultimately the exchange rates. Domestic investment for Germany would hence reduce after some time, as the previous investors prefer to invest abroad in search