Question

Suppose a country wants exchange rate stability but does not have sufficient official reserves to defend a fixed exchange rate. According to the monetary approach, would a country under these circumstances be better served by targeting the growth rate of its price level or the growth rate of its money supply? Explain your answer carefully.

Answer 1

Typically a government maintains a fixed exchange rate by either buying or selling its own currency on the open market. Another method of maintaining a fixed exchange rate is by simply making it illegal to trade currency at any other rate A fixed exchange rate, sometimes called a pegged exchange rate, is a type of exchange rate regime in which a currency's value is fixed or pegged by a monetary authority against the value of another currency, a basket of other currencies, or another measure of value, such as gold.

There are benefits and risks to using a fixed exchange rate system. A fixed exchange rate is typically used to stabilize the exchange rate of a currency by directly fixing its value in a predetermined ratio to a different, more stable, or more internationally prevalent curreny to which the currency is pegged. In doing so, the exchange rate between the currency and its peg does not change based on market conditions unlike in a floating exchange regime. This makes trade and investments between the two currency areas easier and more predictable and is especially useful for small economies that borrow primarily in foreign currency and in which external trade forms a large part of their GDP. Historically the long-term growth rate in real output has been approximately 3 percent per year. If the Federal Reserves allows the money supply to grow at an annual rate of approximately 3 percent, no inflation will occur.

Generally, the central bank will set a range which its currency’s value may freely float between. If the currency drops below the range’s floor or grows beyond the range’s ceiling, the central bank takes action to bring the currency’s value back within range.Management by the central bank generally takes the form of buying or selling large lots of its currency in order to provide price support or resistance. For example, if a currency is valued above its range, the central bank will sell some of its currency it has in reserve. By putting more of its currency in circulation, the central bank will decrease the currency’s value.