Question

How can expansionary and contractionary monetary policies affect aggregate demand through the exchange rate channel?

Short answer

Contractionary policy causes the domestic currency to appreciate thus reducing exports and aggregate demand. Expansionary policy causes the domestic currency to depreciate thus increasing exports and aggregate demand.

Step-by-step solution

Step 1. Concept of  Monetary policy

Monetary policy channels are the channels via which the central bank's monetary policies affect macroeconomic activity. Monetary policy influences interest rates and the accessible amount of loanable funds, which thus influences a few parts of aggregate demand. A tight or contractionary monetary policy that prompts higher interest rates and a decreased amount of loanable funds will decrease aggregate demand.

Step 2. Explanation

An expansionary monetary policy would increase the supply of loanable funds in the market. This would cause the interest rate to decline. This decline in interest rates would cause an outflow of funds to countries with higher interest rates. The domestic currency would be exchanged for foreign currency to invest in other countries. As the supply of domestic currency increases, its value would depreciate. This reduction in the value of the domestic currency would make exports cheaper. As the exports increase, the aggregate demand would increase as well.

Similarly, a contractionary monetary policy would decrease the supply of loanable funds in the market. This would cause the interest rate to increase. This rise in interest rates would cause an inflow of funds from other countries with lower interest rates. The demand for domestic currency would increase, and its value would appreciate. This increase in the value of the domestic currency would make exports expensive. As the exports decline, the aggregate demand would decrease as well.