Question

Discuss two models of exchange determination; one assuming fully flexible prices and one assuming fixed prices. How does the working of monetary policy vary in the two models which the exchange rate is fixed or floating?

Answer 1

Exchange rate determination-

FLEXIBLE- Flexible or floating exchange rate is determined by market forces of supply and demand. If the demand for the currency is high, its value will increase. Imported goods will now be cheaper and local producers will suffer losses. This will, in turn, result in loss of job leading to reduced demand for currency. Thus the auto-correction in the market takes place.

FIXED- Fixed or pegged rate is the rate set by the government and it is maintained as the official exchange rate. It is set against a major world currency. The Central bank buys or sells the currency in return for the currency to which it is pegged. For this, the central bank has to maintain a very high level of foreign reserves.

MONETARY POLICY under perfect capital mobility(where initially domestic interest rate is equal to the foreign exchange rate.)

UNDER FIXED EXCHANGE RATE-

Money supply increases, the LM curve shifts to LM1. Domestic interest rate falls, capital moves out. Exchange rate rises. Foreign goods expensive exports rise, the exchange rate falls output falls back to the initial level.

UNDER FIXED EXCHANGE RATE-

Money supply increases, the LM curve shifts to LM1. Domestic interest rate falls, capital moves out. Since Exchange rate is fixed, the Central bank reduces the money supply. LM1 back to LM.