Question

Recall the Trilemma. Using that knowledge, explain why fixed exchange rate regimes which have international capital mobility do not have an independent monetary policy.

Answer 1

When there is a fixed exchange rate regime and perfect capital mobility, monetary policy has to lose its autonomy because the commitment to maintain the exchange rate weakens the ability to maintain monetary policy. Take for example the case when there is a fiscal expansion. Higher interest rate will attract capital from abroad. Due to perfect capital mobility this will going to appreciate the domestic currency in order to adjust for higher demand for currency. exchange rate appreciation is not welcomed because of fixed exchange rate policy. Monetary authority has to intervene in the market and increase money supply in order to maintain the exchange rate. Take another example of a monetary expansion. Higher money supply decreases the rate of interest and causes capital to move out of the country. This depreciates the domestic currency. Once again in order to maintain the exchange rate the monetary authority has to intervene and decrease money supply in order to maintain the exchange rate.

This indicates that monetary authority has no control over monetary policy in the market and it has to always accommodate for exchange rate changes in order to maintain the commitment of fixed exchange rate. This shows that there is no independent monetary policy when there is a fixed exchange rate with perfect capital mobility..