Question

An important difference between fixed and floating exchange rates is the impact on monetary policy. This difference is framed by some economists as being a benefit of floating exchange rates, but other economists frame the same thing as a benefit of fixed exchange rates. Explain each side of the argument, and then give your own opinion.

Answer 1

Fixed exchange rate is when a country fixes its price in terms of another currency or gold. This way, currency market fluctuations or economic fluctuations around the world do not affect the country's exchange rate in terms of other currency. In contrast, having a floating exchange rate means letting the market for currencies determine the exchange rate between two countries.

Having a fixed exchange rate somewhat limits the ability of the central bank to influence money supply, output, and employment in the economy. Suppose the central bank decides to increase the money supply in the economy. An increase in money supply causes the interest rates in the economy to go down. Now since the home country's interest rates have fallen, the foreign country's currency will be in high demand.

Now if the exchange rate was floating, this would lead to appreciation of the foreign currency and depreciation of home currency. In other words, the exchange rate would rise. If the exchange rate here is fixed, to maintain the exchange rate, the central bank of the home country would sell its reserves of foreign currency to makeup for the excess demand. Now in doing this transaction, home currency is being used and is thus taken out of circulation. This offsets the expansionary monetary policy that the central bank intended to follow.

In order for monetary policy to have any impact on the economic output and employment, the exchange rate must be floating. And expansionary monetary policy will cascade into increase in the level of aggregate demand and output.