Question 1

Exchange rate policy basically refers to the manner in which a country monitor its
currency in respect to foreign currencies and the foreign exchange market. It is also well known
as exchange rate regimes. Generally, after choosing the types of exchange rate regimes, the
country will proceed in choosing the suitable monetary policy. On the other hand, exchange
rate is defined as the rate of the domestic currency that is converted to a foreign currency. This
rate usually determines the expenses of domestic production and finance in respect to foreign
products and capital. Upon choosing the exchange rate policy, it is important to consider
economic shocks in particular into the account. Economic shocks refer to an event that give a
significant change within an economy, it is usually unpredictable and often affects both the
supply and demand of the market (Staff, 2007). Economic shocks are often notable by the
economist as internal and external shocks. To ensure the stability of the economy, countries
usually prefer exchange rate policy that minimises shocks. However, the effect of shocks may
vary with exchange rate regime and with the type of shocks. Under these types of shocks, there
are two most common shocks discuss among the economists, namely real and monetary shocks.
Overall, different exchange rate regime will have different impact of shocks towards an
economy, in this case, the domestic economy.

Domestic economy can be defined as the internal local economy of a country (Sanjani
& Solmaz, 2015). Basically, different types of exchange rate regime will have different impacts
on the domestic economy, depending on types of shocks. In order to understand the mechanism
on how the domestic economy responds to the real and monetary shocks under different
exchange rate regime, it is essential to firstly know the types of exchange rate regime. There
are two types of exchange rate regimes, namely flexible exchange rate and fixed exchange rate.
Flexible exchange rate is defined as a regime in which the forex market set the currency price
based on the supply and demand compared with the other countries. Contrary to this, in fixed
exchange rate, the government entirely determines the rate by tying the official exchange rate
to another country’s currency or to the price of the gold (Staff, 2004). According to Chia et. al.
(2012), some countries prefer flexible exchange rate over fixed exchange rate due to their
ability to insulate the economic more effectively against real shocks. This statement is based
by a hypothesis conducted by Friedman (1953). The researchers added that the reason behind
this is the presence of price stickiness. When an economy is hit by real shock, the economy
that can adjust their relative prices more quickly will have smaller and smoother adjustment in
terms of output. Through flexible exchange rate, the relative prices can be adjusted instantly
via the changes in the nominal exchange rate. Whereas for countries that implement the fixed
exchange rate, the relative price is restricted to be adjusted and will only move at slower speed
that is allowed by the price stickiness. However, this only implies to the domestic respond to
domestic real shock under these two exchange rate regimes.

Monetary shock is also known as one of the external shocks under the economic shocks
terms. It is defined as the changes in the supply or demand of money. Domestic monetary shock
can be easily known as the internal changes in the supply or demand of money within a country.
When there is a changes in the supply of money, economist often refer this as supply shock
which also can be used for monetary shock, same goes to demand shock (Staff, 2004). Under
the fixed exchange rate, for instant, if there is a negative changes in the supply or demand of
money, namely negative monetary shock, the domestic residents will have the tendency to save
instead of spending, the country will also lessen the exportation transaction due to the negative
demand of money. As for the supply, the government will encourage the residents to spend
more and buy more bonds from the central bank. This is to avoid inflation rate from
depreciating. The same goes when there is a positive changes in supply or demand money, also
referred as positive monetary shock. In this case, when there is an increase supply of money,
the country will urge the residents to save their money and will also sell their bonds to the
central bank (Lucas, 1994). As for demand, the country will then increase its export
transportation and increase the exchange rate as well. This is to encourage the appreciating of
the currency.

As for the flexible exchange rate, the changes in the supply or demand of money will
not have the same significant changes as fixed exchange rate. Since the setting of currency is
highly depended on the supply and demand compared with other countries, the exchange rate
are therefore fluctuating in correspond with the monetary shock. For example, when domestic
economy is hit by the negative monetary shock, the exchange rate will be negative since there
is a negative trend of supply or demand of money. In this case, decrease in exchange rate will
cause the domestic inflation rate to increase, the country will urge the residents to spend more
and will tend to sell their bond to the central banks. As for the positive monetary shock, the
exchange rate will be increased which then causes the inflation rate to decrease. In this case,
domestic residents will tend to spend more, export transaction will be in high frequency as
well. However, the fluctuation of monetary shock is totally depending on the supply and
demand of other countries. Unlike fixed exchange rate, fluctuation will always occur and
domestic economy will have to implement effective strategies in anticipating these changes
which then will eventually lead to increases of exchange rate volatility. This will greatly affect
the relationship between exchange rate volatility with the international trade which will be
discussed later.

Shocks in big country often have their significant effects on the small country that
operates primarily, whether it is a domestic shock or a foreign shock. The shocks can be divided
into two types, real or monetary shocks. How domestic economy responds to these shocks are
usually notable among the scholars. Previous section discuss how the domestic economy
respond to the domestic real shock under both flexible and fixed exchange rate. Upon choosing
the monetary policies, a country usually must choose its exchange rate regime first (Floyd,
2005). Suppose there is a positive foreign monetary shock that results in a rightward shift of
the country’s Liquidity-Money (LM) curve, under fixed exchange rate, this will cause the world
interest rate to fall and increases the exports, causing domestic economy to hold additional
money balances, which the country will obtain by selling assets abroad. As for the flexible
exchange rate, the declination in the world interest rate will increase the desired money
holdings of the domestic residents, causing them to try to sell non-monetary assets abroad to
accumulate money which is always fluctuate. In this case, the domestic price level remains
unlike the price level in fixed exchange rate. This correspond with findings obtained by Tseng
(1995) which suggested that the cost of price adjustment can lead to failure in the insulation of
flexible exchange rates towards the impact of foreign monetary shock. The researcher also
stated that under the impact of foreign monetary shock, domestic economy is advisable to
implement flexible exchange rate over fixed exchange rate. However, in the long run, the LM
will tend to return to its original curve, making it more efficient for countries that implement
flexible exchange rate.

As for foreign real shock, there will be an increase in respect to income within the
domestic economy, this will cause its residents to hold a larger stock of money. They will
obtain these additional money holdings by selling non-monetary assets to the foreign residents.
While for the central bank, they will be forced to accumulate foreign exchange reserves, putting
the necessary additions to the money stock in circulation in the process. Understandably, this
is to keep the currency from appreciating. This implies to a country that applied fixed exchange
rate. In a long run, the price level in the foreign country will fall, causing the world interest rate
to fall even further. This will subsequently increase the domestic real exchange rate at the fixed
level of the nominal exchange rate and at any given domestic price level (Floyd, 2006). Moving
to countries with flexible exchange rate, the foreign real shock will put a pressure on the
demand of the money, causing the residents to sell their assets abroad for money, creating an
incipient balance of payments surplus and causing the domestic currency to appreciate. The
price level within the domestic economy will increase. In a long run, the world interest rate
will increase. Shifting the LM curve back to its original curve. However, in flexible exchange
rate, this condition is rarely occur since exchange rate will always fluctuate according to the
fluctuation in demand or supply of other countries. As mentioned earlier, this too will increase
the exchange rate volatility which in turn affect the international trade.

To conclude, the choices of monetary policy is depending on the choices of exchange

rate regime which is between fixed exchange rate and flexible exchange rate. In domestic real
shock, the fixed exchange rate is much favourable than the flexible exchange rate. While
flexible exchange rate is more favourable in the monetary shock due to the demand and supply
by other countries. The same goes to foreign real shock, fixed exchange rate is seen to be more
beneficial compared to flexible exchange rate. As for foreign monetary shock, flexible
exchange rate is more preferable than fixed exchange rate. The preference is summarized in
Table 1.

Table 1: Summarization

Type of Shocks Preferable Exchange Rate

Domestic/Foreign
Regime
Real Shock Fixed Exchange Rate
Domestic
Monetary Shock Flexible Exchange Rate
Real Shock Fixed Exchange Rate
Foreign
Monetary Shock Flexible Exchange Rate

Question 2

Since flexible exchange rate is often associated with the exchange rate volatility among
the economists, hence, this section discusses the definition of exchange rate volatility and its
inverse relationship with the international trade. The exchange rate volatility can be defined as
the unanticipated risk associated with the unexpected changes in the exchange rate (Ilhan,
2006). The source of the exchange rate volatility is believed to be from the economic
fundamentals such as the inflation rate, the interest rate, the balance of payments and so on.
According to Hook and Boon (2000), other factors such as the increment in the cross-border
flows that have been facilitated by the trend towards liberalization of the capital account, the
rapid advancement in technology, and currency speculation also caused the fluctuation of the
exchange rate. Findings conducted by Cushman (1986) and Peree and Steinherr (1989)
revealed that an increase in exchange rate volatility will have an adverse effects on international
trade. These findings are however, interpreted from theoretical studies. Whereas many
empirical studies such as from Clark, Tamirisa, and Wei (2004) confirmed the findings by
stating that increased exchange rate volatility inhibits the international trade or trade flows. On
the other hand, some studies found that there are no significant relationship between exchange
rate volatility and trade (Aristotelous, 2001; Gagnon, 1993). There are also some studies that
claim the positive role of exchange rate volatility towards the international trade. In this
context, the impact of exchange rate volatility under the flexible exchange rate on international
trade is used and discussed.

There is a vast amount of previous and current studies that are being conducted to
examine the relationship between exchange rate volatility and international trade. For instant,
Asteriou et. al. (2016) investigated the effect of exchange rate volatility on international trade
volumes for Mexico, Indonesia, Nigeria, and Turkey. The study revealed that volatility can
significantly affect short-run import and export demand functions. While in the long run, the
study reported that volatility does not affects import and export demand. Major shift from fixed
exchange rate to flexible exchange rate was seen to be influencing the increment of exchange
rate volatility, which then depresses the international trade. In other words, flexible exchange
rate increase the risk of uncertain risk of changes in the exchange rate which then decreasing
the transaction of import and export of a country. This finding is also supported by Danladi et.
al. (2015) which has observed this matter in Nigeria. The shifting of fixed exchange rate to
flexible exchange rate seems to play a vital role in influencing the exchange rate volatility.
Flexible exchange rate indicates that the currency will be set based on the supply and demand
by other countries, the changes in the currency will obviously change and increase the exchange
rate volatility, making other countries to hesitate to invest their trade with the following
country. Hence, the inverse relationship between exchange rate volatility and international
trade is well observed from these studies.

Although there are some authors argue on the positive effect of exchange rate volatility
on international trade, these findings are however, not empirically supported. While some
argues that exchange rate volatility is not the causes of international trade but the consequence
of domestic restrictions to growth, foreign trade disequilibrium and transitory problems
extracted from the differentials impact of interest rates and other factors (Ilhan, 2006). Overall,
the mentioned studies are relevant in demonstrating the inverse relationship between the
exchange rate volatility under the implementation of flexible exchange rate. The following
table summarize the relationship between exchange rate volatility and international trade based
on previous studies.

Table 2: Summarization on the relationship between exchange rate volatility and

international trade

Previous studies Type of relationships Effect

Cushman (1986) and Peree
and Steinherr (1989)
Aristotelous (2001) and
Gagnon (1993)
Doyle (2001) and Bredin et
al. (2003)
Inverse relationship On short-run demand and
supply function
No significant relationship No significant effect
Direct relationship On long-run demand and
supply function

CONCLUSION

To conclude, there are two types of exchange rate regimes that influence the impact of both
real and monetary shock on a domestic economy. Both domestic and foreign real and monetary
shock have different kind of impacts in terms of demand and supply transaction. In foreign
shocks, the income and employment of domestic residents are influenced as well. Overall, fixed
exchange rate is favourable and preferable in both domestic and foreign real shock while in
both domestic and foreign monetary shock, flexible exchange rate is more preferable for
domestic economy. However, the implementation of flexible exchange rate is seen to be a
potential factor of exchange rate volatility. This is due to the fluctuation of exchange rate that
is depending on the supply and demand money of other countries. At the same time, the inverse
relationship of exchange rate volatility and international trade is demonstrated by previous
current studies. The studies show that under flexible exchange rate, increase of exchange rate
volatility will depresses the international trade. However, the studies reported that there is no
significant effect on the import and export transactions in the long run.
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