Monetary Policy Under Fixed Exchange Rate
Governments around the world have financial guidelines, which regulate the market, depending on the existing forces. Such determine many things including the currency exchange rates, taxes, supply and demand forces in the market. These set guiding principles are called monetary policies. Monetary policies can operate under a floating or fixed exchange rate system. In a floating exchange, the price of currency is determined by the market. On the other hand, under fixed exchange rate, demand and supply forces in the market determine the currency price freely without government interventions whatsoever. This article will give you more information on how a monetary policy under fixed exchange rate affects currency prices within the market.
How monetary policy under fixed exchange rate works
Monetary policies operate variedly under a fixed rate system as compared to a floating system. In some cases, the monetary policy may become less effective while fiscal policy becomes super-effective. This points to how the two systems operate differently. Additionally, a government that uses fixed exchange rate system has another policy option. This is the exchange rate policy. While a fixed rate implies that the government should at all times keep the rate fixed, this is not always the case as countries periodically alter their exchange rates depending on market forces.
While this is the case, many market monetarists do not appreciate the role of interest rates as a transmission mechanism. They rather focus on the New Keynesians and Austrians economics. From a traditional point of view, monetary policy works well through various channels within the market and that interest rates happen to be one of them.
Besides interest rates, monetary policy also operates within the confines of exchange rate channel. In understanding how monetary policy under fixed exchange rate works, many economists agree that weakening of a currency can lead to improvement in the country’s Nominal GDP. Even though this is the case, many would concentrate on the real GDP and inflation as opposed to NGDP. However, this observation of how weakening of a country’s currency affects the economy is oftentimes simplified.
The ineffectiveness of monetary policy under fixed exchange rate
A fixed exchange rate allows the government to adopt monetary policies, which are sometimes ineffective depending on the prevailing economic conditions. A good example is the fact this system pushes you to abandon an independent monetary policy. This means that different factors would affect the effective of the policy in the market.
In addition, fixed exchange makes it impossible for a government to use the monetary policy to tame inflation. In this case, you must consider various factors at work before taming poor economic performance. Once the monetary policy under fixed exchange rate is ineffective in addressing issues like inflation, it may put the lives of many people on the line because of high cost of living. In this case, monetary policy becomes a fruitless tool to use to smooth out an existing domestic business cycle. Capital controls offer hope for an independent monetary policy in order to prevent trading of domestic currency. However, capital controls always limit trader and foreign direct investment. Additionally, it prevents more opportunities for massive corruption.
Benefits of Fixed Exchange Rates
Though fixed exchange rate limits a monetary policy in various ways, this type of system equally presents a series of advantages. For example, high exchange rate volatility is not good for the trade. This can arise in cases where more firm focus on the domestic market as opposed to taking the risk of trading internationally because of unfavorable exchange rate moments. Another benefit of a fixed exchange rate in the implementation of a monetary policy is that countries with negative repute can depend on those with a good record of accomplishment for survival. It is a common thing where a country has a history of ineffective monetary policy. By doing this, you are able to adopt the performance of the other country that is performing better. Importantly, one of the extreme ways of addressing the exchange rate is to adopt the currency of another country completely through dollarization. This offers credible solutions than having a nonfunctional monetary policy under fixed exchange rate.
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