Explain the effects of expansionary monetary policy on a country's balance of payments and real product and income with floating exchange rates.

What will be an ideal response?

POSSIBLE RESPONSE: With floating or flexible exchange rates, monetary policy exerts a strong influence over domestic product and income. An expansion of the money supply increases banks' willingness to lend, and interest rates decline. This results in increased borrowing and spending. The drop in interest rates tends to worsen the overall balance of payments in the short run. The current account worsens as imports increase, and the financial account worsens as capital flows out of the country. Foreign investors divest their holdings in the domestic country to invest in other countries that provide investment opportunities with a higher rate of return. These investors buy foreign currency and sell the domestic currency. The incipient worsening of the overall payments balance means that the demand for foreign currency is greater than the supply. With floating exchange rates, however, the pressure results in a depreciation of the domestic country's currency. Depreciation of the domestic currency improves the international price competitiveness of the products produced by the domestic country's firms (assuming that the nominal depreciation is larger than any increase in domestic prices and costs in the short run). 

The improvement in the domestic firms' ability to compete with foreign firms is likely to improve the current account balance, as exports increase and imports decline. The improvement in the current account balance lowers the overall payments deficit reducing, and eventually eliminating pressure for further depreciation of the domestic currency. This exchange-rate adjustment restores external balance. The new competitive edge for the domestic country's firms raises aggregate demand for what the country produces. The extra demand that results from the currency depreciation augments the direct domestic effects of the increase in the money supply. Because of the extra demand, real domestic product and income increase even more. The depreciation may also enhance the effects of monetary policy on the price level and inflation rate. The currency depreciation results in higher domestic prices for imported products, and the extra demand can create general upward pressure on prices. The induced change in the exchange rate reinforces the standard domestic effects of the expansionary monetary policy.