Q. Consider the following statements:
1. Tight monetary policy of the US Federal Reserve could lead to capital flight.
2. Capital flight may increase the interest cost of firms with existing External Commercial borrowing (ECBs).
3. Devaluation of domestic currency decreases the currency risk associated with ECBs.
Which of the statements given above are correct?
Exp: Option a is the correct answer.
Tight monetary policy is an action undertaken by a central bank such as the Federal Reserve to slow down overheated economic growth. Central banks engage in tight monetary policy when an economy is accelerating too quickly or inflation—overall prices—is rising too fast.
Statement 1 is correct: Central Banks enact monetary policy to keep inflation, unemployment, and economic growth stable and positive. When the economy overheats central banks raise interest rates and take other contractionary measures to slow things down – this can discourage investment and depress asset prices. Thus, tight monetary policy of the US Federal Reserve could lead to capital flight by the investors.
Statement 2 is correct: Capital flight can drive up the interest costs as there is reduced money supply in the system. Thus, it would lead to increase in the interest cost of firms that have external commercial borrowings.
Statement 3 is incorrect: Devaluation of domestic currency does not affect the External Commercial Borrowings as it is denominated in the foreign currency and not in the domestic currency.
https://ies.princeton.edu/pdf/S58.pdf
https://blogs.imf.org/2022/01/10/emerging-economies-must-prepare-for-fed-policy-tightening/
