The Effect of Fixed Exchange Rates on Monetary Policy

The Effect of Fixed Exchange Rates on Monetary Policy

The monetary policy of a country depends of different economic conditions. These conditions may determine the system to adopt in order to meet targets and address economic threats like inflation. A common system that affects monetary policy is the fixed exchange rate. This takes place when the government uses another country’s currency as a benchmark to maintain the value of its currency. Under these exchange rates, countries link a semi-fixed rate, allowing the currency to fluctuate within a small target margin. The effect of fixed exchange rates on monetary policy is always significant, forcing governments to take appropriate decisions depending on the prevailing conditions.

Overview of the effect of fixed exchange rates on monetary policy

A government has the option to operate under fixed exchange rates or floating rates. These systems present different conditions and give varying economic results. By choosing fixed exchange rates, a country gets an alternative policy called exchange rate policy. While a fixed exchange rate literally implies that, a country has to maintain its rate, this changes oftentimes depending on current economic conditions.

Noteworthy, choosing a particular exchange rate regime is an important macroeconomic choice. This is so especially when dealing with small open economies. Thus, the choice of deciding whether to fix the rates or leave settle for a floating system could determine a country’s monetary options and the capability to keep open capital markets. Even though this choice has significance, economists do not agree on the effect of fixed exchange rates on monetary policy.

Coding fixed exchange rates

For countries that choose to maintain fixed exchange rates, it is possible to put them in classes, depending on a specific formula. The International Monetary Fund, IMF, monitors the status of every country in the world once they declare their exchange system. This classification forms a coding basis for countries that subscribe to a fixed exchange rate. However, most researchers focus on the real behavior of a country and not the presumed status since many countries do not characterize their behavior correctly, thus undermining the accuracy of the findings. For example, some countries will not announce to keep a fixed, despite keeping one while others do not declare their pegged systems.

The most important thing when classifying a country’s economy is the degree of change on the exchange rate and enough evidence to reveal the impact of a pegged system and not the absence of economic shocks. To do this, it is possible to do this by examining the change in the exchange rate. This would help determine the stability of the rate. In understanding the effect of fixed exchange rates on monetary policy, it can be sometimes challenging to use a constant exchange rate as the only factor to consider when differentiating exchange rate commitment from lack of shocks.

Understanding the effect of fixed exchange rates on monetary policy

Oftentimes, a fixed exchange rate system leads to a loss of monetary autonomy for countries, which maintain this system when they have open capital markets. This means that to get an accurate view of the functionality of the system, one must consider some degree of capital controls. Limits on payment for capital transactions offer an imperfect approach determining the intensity of controls. However, economists largely consider it because it appears across samples of research.

Another important factor to consider when discussing the impact of a pegged exchange rate on monetary policy of a country is devaluation. Devaluation leads to a wide range of effects. The first one is relative-price effect. Devaluing a country’s currency makes local products cheaper than foreign products. However, once price competitiveness improves, the trade balance will also improve, making consumers to shift from foreign commodities to domestic products.

Moreover, devaluation of a currency because of a fixed exchange rate worsens a country’s terms of trade. It may also lead to a drop in real income, and exports fall in price as imports become expensive. Thus, the effect of fixed exchange rates on monetary policy cuts across the economy sphere. When it happens, everyone feels the impact, from the local producers like farmers to leading exporters and importers of a country.

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