Question

Fixed exchange rates and monetary policy

Consider a group of open economies with perfect capital mobility among them.

a) Assume that there is a Leader country. All other countries (referred to as the Follower countries) fix their exchange rates to the Leader country. Discuss the effectiveness of monetary policy in the Follower countries.

(b) If the Leader country reduces its money supply to fight inflation, what must the Follower countries do to enforce their fixed exchange rates? What is the effect on their economies? What would happen if the Follower countries did nothing?

Answer 1

It is assumed that all the economies are open with perfect capital mobility. Further, there is one leader country, and all other followers fix their exchange rate to the leader country.

a) In this case, monetary policy will be completely ineffective in the follower countries. Their decision to fix their exchange rates to the leader, makes them completely dependent on what the leader does. They can use monetary policy only if the leader has also done so.

For example, assume that one of the followers decides to increase money supply, to stimulate domestic consumption. Due to this, interest rates will fall domestically. Capital outflow will take place, imposing pressure on the currency to depreciate. To stick to the exchange rate and prevent depreciation, the country will have to decrease the supply of money again, or to buy back its own currency from the forex market. This leads to reversal of the original decision.

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b) If the leader reduces money supply, its interest rates will rise and currency will appreciate. Now since the followers have fixed their exchange rate, they also need their currency to appreciate. They need to have higher interest rates.

One option is for the government to increase borrowings and run a deficit, so that interest rates rise. The followers may also attempt to reduce their money supply, as well. Since the leader has done so, there is some scope for the followers to do so.

In either case, high interest rates will make domestic borrowing costlier, and may reduce aggregate demand. Saving may rise, but consumption will fall. Exports may become costlier. High interest rates may also lead to capital inflow, and exert pressure on the currency to appreciate further.

If the followers do nothing, the currency peg may get broken. The followers will not be able to maintain the peg, and their governments may need to intervene. Valuation of the currency will change, and a new peg may need to be created.