Which of the following policies help to raise interest rate unambiguou

Which of the following policies help to raise interest rate unambiguously and thereby lead to appreciation of currency?

Expansionary fiscal and monetary policy

Contractionary fiscal and monetary policy

Contractionary fiscal policy and expansionary monetary policy

Contractionary monetary policy and expansionary fiscal policy

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UPSC CDS-1 – 2023

The correct answer is D) Contractionary monetary policy and expansionary fiscal policy. Contractionary monetary policy (e.g., raising interest rates, selling bonds) directly increases interest rates. Higher interest rates attract foreign capital seeking higher returns, increasing demand for the domestic currency and leading to its appreciation. Expansionary fiscal policy (e.g., increased government spending, lower taxes) increases aggregate demand and can also lead to higher interest rates due to increased government borrowing (crowding out) and increased economic activity, further reinforcing the upward pressure on interest rates and potentially the currency. This combination is known to lead to higher interest rates and currency appreciation in open economies with capital mobility.

– Monetary policy directly influences interest rates and money supply. Contractionary monetary policy raises interest rates.
– Fiscal policy influences aggregate demand through government spending and taxation. Expansionary fiscal policy increases demand.
– In open economies with capital mobility, higher domestic interest rates relative to foreign rates attract capital inflows, increasing demand for the domestic currency and causing appreciation.
– Contractionary monetary policy is the most unambiguous tool to raise interest rates. Combined with expansionary fiscal policy, which also puts upward pressure on rates (via crowding out and demand), it creates a strong force for higher interest rates and currency appreciation.

This policy mix can lead to a stronger currency and potentially higher interest payments on government debt but may have mixed effects on output depending on the relative strength of the policies and the degree of capital mobility. Option B (Contractionary fiscal and monetary) would also raise interest rates and appreciate the currency but by reducing overall demand, potentially leading to lower output compared to option D. However, option D provides a clearer and more direct path to higher interest rates and appreciation driven by both capital inflow incentives (monetary policy) and potential crowding out/demand pressures (fiscal policy).

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