Effects of Fixed Exchange Rates on Monetary Policy
Many researchers have been busy conducting studies on the impacts that fixed exchange rates can have on monetary policy. The studies are still on-going; however, there are a few revelations that have been made on how pegged exchange rates can impact monetary policy. One thing to be noted is that fixing the rate of exchange does not contribute to the total loss of flexibility with regards to monetary policy. Quite a number of countries would still have monetary freedom with fixed exchange rates but with certain limitations.
With a fixed exchange rate, a country’s monetary policy is limited to a certain parameter. A pegged exchange rate limits a government to making decisions based on the activities of the base country. This means that even if the fixed economy is faced with a problem like inflation, it cannot find solace by increasing supply of money into the market. The exchange rate will still remain the same as long as there is no agreement between the fixed economies to effect changes. Thus, even the current account balances of every pegged economy will remain the same until it opts out or comes into agreement with its partners to change the rates.
A country that operates on a fixed exchange rate is not autonomous; this means that it cannot be able to pursue its domestic objectives through monetary policy. It often occurs that most countries that are operating on fixed exchange rates push much of the autonomy of their monetary policies to the base countries or those nations to whom they have tied their currencies to. Fixed exchange rate economies substantially align their monetary policies to those of their base counterparts, thus limiting their flexibility.
Many business analysts have argued that monetary policy is ineffective under pegged exchange rates. The reason for this is because with a fixed exchange rate, it is not within the power of the government or even the central bank to determine the value of its currency. The fixed exchange rate reigns over monetary policy in that even if a country decides to either expand or contract its monetary policy, the fixed exchange rate will not change to the advantage of that country. A fixed exchange rate takes away the ability of a government or the central bank to influence the interest rates, exchange rates and even the Gross National Product.
In the implementation of a fixed exchange rate, there is always an initial target exchange rate that is set. This rate will be allowed to undergo fluctuation within a given range that is close to that target. Economies that are operating with the fixed exchange rate will have to keep their rates revolving around this target. However, modifications can be conducted on the exchange rate after some time depending on the performance of economies. Thus, the effects of a fixed exchange rate on monetary policy can only be achieved when these modifications are done.