Monetary Policy under Fixed Exchange Rates

1. CB attempts to stimulate economy (buys domestic assets) 2. E0 ⇒ E2 ; AA1 ⇒ AA2 3. But CB is pegging! Can’t allow depreciation to happen 4. So the CB sells foreign reserves to move E2 ⇒ E0

⇑
(depreciation)

5. This brings exchange rate back to E0, and forces AA2 back to AA1 6. Monetary policy is ineffective under fixed exchange rates

1

Monetary policy ineffective under fixed exchange rates
• With a fixed exchange rate, you give up on

an independent monetary policy. You cannot use monetary policy to target domestic inflation or to try to smooth out the domestic business cycle • The only hope for independent monetary policy is capital controls to prevent traders buying or selling domestic currency • But capital controls reduce trade and foreign direct investment, and present opportunities for corruption

2

Fiscal Policy under Fixed Exchange Rates
Fiscal policy is more effective under fixed exchange rates

1.

Fiscal stimulus (increase spending; lower taxes increases aggregate demand (shifts DD to right) But this causes initial appreciation (fall in E); equil is at 2. To protect the peg, CB must buy foreign assets with home currency. This increases the domestic money supply, which moves economy to final equil 3 (higher output) Fiscal policy is potent because it causes both the DD and the AA schedules to shift 3

2.

⇓
(appreciation)

3.

4.

Disadvantages of Fixed Exchange Rates
• With a fixed exchange rate you give up on an independent monetary policy • So you cannot use monetary policy to target domestic inflation or to try to smooth out the domestic business cycle • The only hope for independent monetary policy is exchange controls to prevent traders buying or selling domestic currency • But exchange controls reduce trade and foreign direct investment, and present opportunities