Question

Discuss the implications for the economy if a country moves on to a fixed exchange rate regime in the year 2018. Take a broad view of economic parameters.

Answer 1

The Fixed Exchange Rate

A fixed exchange rate system or pegged exchange rate system is one in which the government wants to maintain a fixed exchange value of the currency against any other currency. The worth of the currency of a country is decided in terms of fixed weight of an asset, another currency or basket of other currencies. The central bank of the country remains involved in the buying and selling of these currencies at a given fixed price.

The reserve of foreign currency and gold is tried to be maintained by the government which follows the pegged exchange rate system. In order to intervene in the foreign exchange market, the government can sell the reserves in order to fulfill the increased demand or to take up the excess supply of home currency.

If we are operating in a true fixed exchange rate system in which there is a confidence of the market participant on the fact that there will be no change in the exchange rate prevailing today and in the future i.e. E=E-e and thus domestic interest rate will be equal to the foreign interest rate. In these situations, there will be varied money supply. In fact, the money supply has to be used by the central bank as a measure to maintain the equality between the foreign interest rate and domestic interest rate.

Let us consider that the official exchange rate is 1.1. If there is a shift in DD curve resulting due to any reason let us consider that increase in investment expenditures, thus for maintaining the official exchange rate, the money supply will have to be raised by the central bank. This will result in a rightward movement in AA curve and this will bring the exchange rate back to the value of 1.1, the role which is played by the monetary policy can be termed as completely passive in these events.