Question

In details, give an explanation to the reason a central bank that operates in the fixed exchange rate regime has no control in the long run over money supply. incorporating the control of inflation

Answer 1

* Under perfect capital mobility and fixed exchange rate system a country cannot pursue an independent monetary policy.With perfect capital mobility interest rate cannot move out of line with those prevailing in the world market.Any attempt at independent monetary policy leads to infinite capital flow and therefore need for central bank to intervene in market so that domestic interest rate returns back to world interest rate.

* As shown in the dig. if there is a monetary expansion then LM curve shift rightwards and interest rate decreases.As a result there will be outflow of capital and deficit in BOP.Due to this there will be pressure for currency to depreciate.However to keep exchange rate fixed central bank will intervene by selling foreign money and purchasing domestic money. This results in monetary contraction which increases interest rate and it return backs to the initial level. (i=if).

*Therefore, Internal & external balance is attained at the same level of output .That is why it is said that under fixed exchange rate system money stock is endogenous i.e.. central bank has no control in long run over money supply.The essential point is that commitment to maintain fixed exchange rate makes money stock endogenous because central bank has to provide foreign exchange or domestic money that is demanded at fixed exchange rate.

*We must note that devaluation increases Net Export which increases Aggregate Demand resulting into increase in domestic price.But increase in domestic price reduces effectiveness of devaluation.Therefore when a country experiences inflation above the rate of inflation of its trading Partner then holding exchange rate would imply,loss of competitiveness and thereby increase in deficit.

*Therefore, in order to avoid increase in deficit country follows crawling peg exchange rate.In this policy exchange rate is adjusted at a rate roughly equal to inflation difference between home country and its trading partner so that real exchange rate remains constant.