Question

Explain the connection between the exchange rate regime, the money supply and monetary policy independence.

Answer 1

When a country follows a fixed exchange rate regime then,

Suppose there is an appreciation of the domestic currency then the Central Bank has to increase the money supply i.e. use monetary expansion to bring back the exchange rate at fixed level. Similarly, when a country wants to control its inflation rate, it uses monetary contraction which reduces money supply and thus, interest rate. This causes net capital outflow to increase and domestic currency to depreciate. Thus, to bring the exchange rate back to fixed level, the Central Bank has to increase money supply i.e. monetary expansion. Thus, nor the money supply or monetary policy are interdependent. Although when a country follows a floating exchange rate regime then depriciation or appreciation of currency is not to be offset by changes in monetary policy making it independent.

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