CFA Level II ExamEconomicsMedium
A central bank is considering implementing quantitative easing to stimulate economic growth. A macroeconomist is assessing the potential impact on the domestic currency's exchange rate. Assuming the country operates under a flexible exchange rate regime and other central banks do not react, what is the most likely immediate effect of quantitative easing on the domestic currency?
- ADepreciation, as the supply of domestic currency in the financial system increases.
- BNo significant change, as QE primarily targets long-term interest rates.
- CAppreciation, due to increased investor confidence in the economy.
- DAppreciation, as lower long-term interest rates attract foreign bond investors.
Show answer & explanationAnswer & explanation
Correct answer: A. Depreciation, as the supply of domestic currency in the financial system increases.
Quantitative easing involves the central bank purchasing government bonds and other securities, which increases the money supply in the financial system. An increased supply of domestic currency, all else being equal, tends to reduce its value relative to foreign currencies, leading to depreciation.
Why the other options are wrong
- B. Incorrect. While QE targets long-term rates, its effect on the money supply and interest rate differentials can have a significant impact on the exchange rate.
- C. Incorrect. While confidence can play a role, the direct monetary effect of QE is typically currency depreciation.
- D. Incorrect. Lower long-term interest rates would make domestic bonds less attractive to foreign investors, leading to capital outflow and depreciation, not appreciation.
Quantitative Easing (QE)
A monetary policy where a central bank purchases large quantities of government bonds or other financial assets to increase the money supply and lower interest rates.
- Used when conventional monetary policy (e.g., lowering policy rates) is ineffective.
- Aims to stimulate economic activity by lowering long-term interest rates and increasing liquidity.
- Can lead to currency depreciation, as it increases the supply of domestic currency.
Memory trick: QE floods market, currency sinks.