Question

If a country chooses to have a monetary policy oriented toward domestic goals and the freedom of international capital movements, then it could have a floating exchange rate. Why is this the case? How would a fixed exchange rate compare to it instead?

Answer 1

This belongs to the Trinity of international finance in which all the three possibilities, fixed exchange rate perfect capital mobility and monetary policy autonomy cannot exist simultaneously in an economy. If a country chooses to have an independent monetary policy, and that there is a perfect mobility of capital, then there cannot be a fixed exchange rate.

This is perhaps because whenever there is a fixed exchange rate, the central bank will have to commit itself to maintain that exchange rate and in doing so, it has to give up it's autonomy over the monetary policy. Suppose central bank is willing to combat recession by using monetary expansion. This will reduce the rate of interest depreciate the currency and capital will move out of the country, in net terms. To maintain the exchange rate at its fixed value, the central bank will have to reverse its decision and will be using monetary contraction, which appreciates the currency and therefore, negates the previously done depreciation

It then appears that if the central bank is willing to have an independent monetary policy along with a perfect capital mobility, it can do so only under a floating exchange rate regime.