China has long pegged its currency (the Yuan) to the U.S. dollar. Assuming the free flow...

China has long pegged its currency (the Yuan) to the U.S. dollar. Assuming the free flow of capital across borders, explain why China cannot have an independent monetary policy reaction curve with a fixed currency.

Expert Solution

This is perhaps because perfect capital mobility and fixed exchange rate do not allow the monetary policy to be independent which is known as Trinity of international finance.

If there is a fixed exchange rate, and there is a deliberate monetary contraction to pacify the heating economy, there will be an increase in the rate of interest which will result in capital inflows due to perfect capital mobility. Currency will appreciate as net capital outflow decreases. Since central bank is committed to maintain the fixed exchange rate, it has to reverse it's policy decision of monetary contraction and instead, it implements monetary expansion, releases domestic currency in the market to depreciate the appreciated currency and bring its value back to the fixed exchange rate

So we see that when there is a fixed exchange rate and perfect capital mobility, there cannot be an independent monetary policy

Rahul Sunny answered 1 year ago

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