Question

Does fixed exchange rate carry costs including possible exchange rate crisis if the market loses confidence in the fixed rate and less political pressure for the central bank to have an inflationary boom before an election?

Answer 1

Fixed exchange rate system is a regime that involves different monetary policy tools under the pressure of the government so that exchange rate of domestic currency is fixed against other major currencies in the world. It requires a backing of sound economic conditions and growth of the economy. But, it incurs a cost as when rest of the world loses confidence, then government is force to forego fixed exchange rate system and adopt flexible rate. The government under pressure, brings less control over the central bank and its monetary policy. As a result, central bank slowly starts making domestic currency to realize its true value against other major currencies in the world. It leads to depreciation of the domestic currency and price level increases. It gives to sharp increase in the inflation rate and FIIs runaway from the market. It increases the supply of domestic currency and inflation rises further. It brings financial as well as economic crisis to the country that is treated as a huge cost to the economy.