The monetary policy of the country focuses on controlling the supply of the money in an economy so that the targeted inflation and interest rate could be maintained destined for the overall growth of economic parameters. Generally, the central bank of the country formulates the monetary policies. And the fixed exchange rate regime is a condition where the exchange rate of currencies is kept fixed irrespective of the actual market interaction. I fell it more like an intervention, but often the country does so, let’s see some scenarios.
At an extreme scenario of perfect capital immobility where the countries tighten their regulation to stop the capital flight, the implication of the monetary policy through increase supply of the money could be an increase in the income which may increase the imports. Graphically, the expansionary monetary policy will shift the LM curve to the right creating the deficit position. Here the demand for the foreign currency increases ultimately appreciating it and depreciating the home currency. So, the central bank to maintain the fixed exchange rate has to sale the international reserve that it has in its vault, in doing so the LM curve shift back to its original initial position.
At another scenario of perfect capital mobility where the countries are allowed to trade the capital across the border, the expansionary monetary policy will increase the income and the imports as in the case of perfect capital immobility but here the interest rate remains constant as investors seek other international investment with higher returns. The initially shifted LM curve (due to the supply of money) which increases the demand for the foreign currency pressurizes for the appreciation of foreign rate. So, once again to maintain the fixed rate, the regulator body rolls back LM to initial phase by the supplying foreign currency it has.
So from the above cases, we can infer that the monetary policy if a country has a fixed exchange rate regime become a non-autonomous policy which rather than focusing on the overall economic growth through reducing the unemployment rate and increasing output has to focus on maintaining the fixed exchange rate regime.
But interestingly, the rollback (i.e., shift of LM curve to the initial) position could be delayed. The monetary authorities could undertake open-market purchases of the domestic securities to maintain the domestic money supply (Appleyard & Field, 2014). Further, as per the economic literature “the impossible trinity”; i. the independent monetary policy ii. free capital mobility iii. fixed exchange rate does not exist at once. Any two could be controlled at the expense of remaining. So, in the above case if we undertook free capital mobility and fixed exchange rate than we don’t have an independent monetary policy
But in times, if a country goes into the fixed exchange rate regime with calculated monetary policies in hand, and if a home currency rate is devaluated it will increase its exports but makes its import dearer. This will shift the IS curve (as export increase) and the BP (due to surplus BOP) towards the right. Now here the central bank enjoys the surplus in of BOP and purchases the foreign exchange to hold the new value of the currency, and it ultimately increases the money supply shifting the LM curve to the right and attaining the new point of increased income level(Y).
An example to share, Nepal has a peg exchange rate system with India, Rs.160Nrs (Nepali Currency) is equivalent to Rs100IC (Indian Currency). The bilateral foreign exchange rate regime for fixed exchange rate was made by Nepal with India to reduce the trade deficit or the risk of bubbling trade deficit which also has direct implication in BOP. Nepal has nearly 60% of the trade relation with India which is also a neighboring country, and the peg system has been maintained so that Indian currency appreciation might not erode the trade deficit which is already in billions of dollars. Here the Nepal Rastra Bank (NRB, the central bank of Nepal) though have little control over the monetary policies, it most of time focuses on buy and sell of Indian currency to maintain the rate.
At the one hand, perfect capital immobility and other hand fixed exchange rate regime which is further amalgamated with ineffective productive sectors (manufacturing and services) has created underdeveloped private sector. Nepal has been in a loss since decades as it has fixed exchange rate structure with India with whom it has more than 60% of trade relations. And for the remaining 40%, the home currency is depreciating exponentially and increasing the trade deficit since we hardly have comparative advantage in the manufactured goods and our export to import ratio in values hovers around 1:16
Hence, under fixed exchange rate regime monetary policy could not be a better option for the countries to incline with, but often countries adopt it, as mentioned above in the case of Nepal, where it has pegged its currency with India alone. But in totality, it is seen that the country with capital mobility if incorporates fiscal policy, will be a better option in fixed exchange rate regime.
Bibliography
Appleyard, D. R., & Field, A. J. (2014). International Economics. Irwin: McGraw-Hill.
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