Question

If a country fixes its exchange rate but keeps its capital markets open to international flows, what does it give up? Explain, and show.

Answer 1

A fixed exchange rate system, also referred to as a pegged system refers to a system of foreign exchange in which the currency of a nation is fixed or pegged by the monetary authority against another currency or basket of currencies or items like gold. Unlike a floating exchange rate system, in this system, the exchange rate does not vary in accordance with the market forces and is usually implemented at times to stabilise the currency of a nation and makes the trade easier and more predictable. A fixed exchange rate is also used in such situations when the inflation rates are high so as to reduce its effects.

                                    Mundell-Fleming model can be used to explain the effects of increased capital flow and a fixed exchange system for an economy. According to this model, it says that with the capital market open to international flows in an economy that as a fixed exchange rate system, it would weaken the ability of the government to use domestic monetary policy to achieve macroeconomic stability in the nation. Mundell-Fleming model states that it is not possible for an economy with a fixed exchange rate system to achieve the ‘trinity’ ie; maintaining a fixed exchange rate, free capital movement and independent monetary policy. He called this as the ‘impossible trinity’ In such a case, the central bank sells foreign currency so as to maintain he desired exchange rate and to buy the domestic money which causes and increase in the exchange rate of the domestic currency. The following are believed to be the effects of having a fixed exchange rate system and maintaining a free capital market on an economy

· The economy would lose it’s power of maintaining a domestic foreign policy to attain macroeconomic stability

· It would restrict the ability of automatic rebalancing to adjust the balance of trade effects.

· The country may face reduction in the foreign exchange reserves which could lead to balance of payment crisis and devaluation of the domestic currency.

· The freedom to use fiscal policy measures would also be restricted under such circumstances.

· When international flow increases, the pegged rate of exchange may not equal the market equilibrium rate and may result in excess demand or supply in the market.

· It may lead to inefficient allocation of resources.

                                                    The above causes are the results of maintaining a fixed exchange rate regime along with international flows in to a market. The major challenge here remains in losing the ability to frame domestic monetary and fiscal policies in a free manner that ay lead to many further troubles in the economy as discussed above.