Monetary Policy under Fixed Exchange Rate
Many economists and business analysts have questioned the formation of monetary policy and how effective it can be under a fixed exchange rate. There have been varied opinions with some pointing out that it is ineffective and others the opposite. This paper gives a detailed review of the behavior of monetary policy under fixed exchange rate.
When the exchange rate is fixed, there is no need for an independent monetary policy. The idea of using monetary policy to target inflation in domestic circles is null and void. Besides, monetary policy cannot be used to tone down the business cycle of a government that has implemented the pegged exchange rate. It would only be wise for the country to exercise capital controls in order to hinder trades from participating in the sale and buying of domestic currency.
Even though the capital controls would seem to be an attractive measure for an independent monetary policy, it also has certain consequences. Exercising capital controls can significantly curtail foreign direct investments and trade. Besides, it can also create loopholes in the system, resulting into corruption and other malpractices.
With a fixed exchange rate, the central bank or government does not have the ability to raise money supply in order to enhance the expansion of Gross National Product. In fact, this is why many countries find it hard to maintain the autonomy of their currencies whenever they implement the policy of a fixed exchange rate. The central bank is ripped off the power of influencing the interest rates, levels of Gross National Product and exchange rates.
If there is a monetary policy that increases the supply of money, an upward pressure will be exerted on the exchange rate. An example can be the case of the US fixing its exchange rate to that of Britain. What will happen is that the United States’ rate of return on assets will be reduced below that of Britain. Thus, the prices of US assets will be significantly lowered such that traders will be demanding more pounds in exchange for dollars. The end result is that the dollar will depreciate while the pound appreciates.
Since US maintains a pegged exchange rate, the government will be pushed to intervene in order to avoid the demand for more pounds in exchange for the dollar. The government will act by bridging in the gap through the supply of the excess pounds that are required by traders. The best way that it will do this is by selling its reserves of pounds at the pegged exchange rate in exchange for US dollars.
Whether a government implements a contractionary or expansionary monetary policy, there will be no impact if it operates on a pegged exchange system. There will be no change on the exchange rate; neither will there be an impact on current account balance and equilibrium gross national product. The bottom line is that monetary policy is ineffective under fixed exchange rate.
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