Monetary Policy under Fixed Exchange Rate

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Monetary Policy under Fixed Exchange Rate

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Introduction

• Many economists and business analysts have
  questioned the formation of monetary policy
• This is how effective it can be under a fixed
  exchange rate.
• There have been varied opinions .
• Some point out that it is ineffective and others
  the opposite.
• Let us consider the behavior of monetary policy
  under fixed exchange rate.

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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.
• Monetary policy cannot be used to tone down the
  business cycle of a government.
• This is if it has implemented the pegged exchange
  rate.
• It would only be wise for the country to exercise
  capital controls.
• This will hinder trades from participating in the
  sale and buying of domestic currency.

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Capital Controls

• Exercising capital controls can significantly
  curtail foreign direct investments and trade
• It can also create loopholes in the system.
• This can result into corruption and other
  malpractices.

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• Fixed rate makes the central bank easier.
• It does not have the ability to raise money
  supply .
• This is in order to enhance the expansion of
  Gross National Product.
• This is why many countries find it hard to
  maintain the autonomy of their currencies .
• This is in relation to 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.

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Sample Case

• If there is a monetary policy that increases the
  supply of money, an upward pressure will be
  exerted on the exchange rate.
• In the case of the US fixing its exchange rate to
  that of Britain.
• United States rate of return on assets will be
  reduced below that of Britain.
• The prices of US assets will be significantly
  lowered.
• Traders will be demanding more pounds in exchange
  for dollars.
• The end result is that the dollar will depreciate
  while the pound appreciates.

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• Since US maintains a pegged exchange rate, the
  government will be pushed to intervene.
• This will be in order to avoid the demand for
  more pounds in exchange for the dollar.
• It 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.
• This will be at the pegged exchange rate in
  exchange for US dollars.

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