Why does a Fixed Exchange Rate prevents a country from using domestic monetary policy for macro stability?
Can’t we raise interest rates in order to prevent capital flight and hyperinflation?
Also, fixed exchange rates is not "fixed" since the government can easily devalue the currency through capital controls or foreign exchange reserves trade.
Firstly, sure, the fixed rate isn’t fixed, since it can be moved to another rate by the government any time it wants. However, that defeats the purpose of declaring a fixed rate–fixed rates function as a signal to others that the country is establishing a stable foundation for its economy and is encouraging foreign investment. If the country declares a fixed rate and then changes it every month, then there really is no point in having one to start with.
To address the main question, in brief, it doesn’t. A fixed exchange rate allows for domestic monetary policy independence (i.e. interest rate control, etc) so long as the country is willing to give up the prospect of maintaining capital controls. Alternatively, you could have a fixed FX rate and capital controls, but then you cannot have monetary policy independence. This is known as the "inconsistent trinity" of the Mundell-Fleming model. So, yes, you can raise interest rates to try to prevent capital flight, but you should know that, by doing so, you cannot maintain both a fixed FX rate and any capital controls which may be in place: one of the latter two would have to go.
April 7th, 2010 at 8:40 pm
Sure the country can impose/abolish capital controls or restrict/loosen FX trade. Even more intuitively, it can also use open-market operations for ANY reason.
The point, however, is that you have a numerical target for the FX rate. Open-market operations, changes in capital controls, etc., of course move the FX rate. A fixed-exchange rate regime gives up domestic monetary policy independence. You only buy or sell your currency to keep the FX rate fixed. If you buy or sell your currency for any other reason, you’ll inadvertedly move the FX rate away from the target, conflicting with the goal of a fixed FX rate.
In others words, in most reasonable models, there is only one stance of monetary policy (where you can think of the "stance of monetary policy" as an aggregate of all the monetary policy instruments at your disposal) consistent with a fixed exchange rate. This stance is consistent with ONE fixed exchange rate, but at the same is consistent with ONE inflation rate, ONE level of aggregate economic activity, ONE short-term interest rate, etc.
References :
April 7th, 2010 at 9:24 pm
Firstly, sure, the fixed rate isn’t fixed, since it can be moved to another rate by the government any time it wants. However, that defeats the purpose of declaring a fixed rate–fixed rates function as a signal to others that the country is establishing a stable foundation for its economy and is encouraging foreign investment. If the country declares a fixed rate and then changes it every month, then there really is no point in having one to start with.
To address the main question, in brief, it doesn’t. A fixed exchange rate allows for domestic monetary policy independence (i.e. interest rate control, etc) so long as the country is willing to give up the prospect of maintaining capital controls. Alternatively, you could have a fixed FX rate and capital controls, but then you cannot have monetary policy independence. This is known as the "inconsistent trinity" of the Mundell-Fleming model. So, yes, you can raise interest rates to try to prevent capital flight, but you should know that, by doing so, you cannot maintain both a fixed FX rate and any capital controls which may be in place: one of the latter two would have to go.
References :