The Forces Of Monetary Policy And Fixed Exchange Rates Essay Sample

A government has the responsibility of ensuring economic growth and social welfare or life standards. To achieve both, it needs to apply correct economic mechanisms and tools like exchange rate regimes. The major dilemma lies between a fixed and floating or flexible exchange rates. The advocates of floating rates favor the independence of monetary policy along with its benefits while the proponents of keeping the exchange rate fixed cite low inflation, price control, better investment, and trade stability as the benefits of rate fixation. Their adversaries consider pegging capable of reducing investment and trade stressing on the possibility of corruption aggravation. However, counterarguments refute their presumptions receiving a solid statistical backing of the International Monetary Fund. The ability to lower inflation alone is the reason government like that of Demark choose a fixed exchange regime since corruption spells social discontent, gradual impoverishment, and poor international competitiveness. The point is that a number of disadvantages a fixed exchange rate reportedly has do not seem to have a solid piece of evidence behind, which makes this option beneficial for a national monetary policy.
Division of Social Sciences (n.pag.) suggests that monetary policy remains inefficient under the regime of pegged exchange rates. Independent monetary policy is abandoned under the fixed regime. Monetary policy is impossible to apply for sorting out the national business cycle or target inflation nationwide. Capital controls keeping traders from selling or purchasing domestic currency are believed to be the sole hope for independent monetary policy. However, such controls do decrease foreign direct investment and trade creating a breeding ground for corruption (Division of Social Sciences n.pag.). Econometrics Laboratory (20) holds that a floating regime ensures monetary policy autonomy. Monetary control is restored to central banks. Moreover, every state can opt for an intended long-run inflation rate of its own. Exchange rates as automatic stabilizers and symmetry are other reported advantages of a flexible or floating regime (Econometrics Laboratory 20). Such are the predicted outcomes for monetary policy under exchange rate pegging and the direct benefits of a floating rate.
Still, Ickes (1) states that it is flexible exchange rates that add uncertainty to trade, with importers and exporters having no way of knowing the exact value of a currency. The higher the volume of trade is, the higher the degree of uncertainty will be. What is more, fixed exchange acts as a nominal anchor to the level of prices, which follows from the incapacity of implementing an autonomous monetary policy under pegged rates. Fixing the rate enforces monetary discipline while the forfeiture of monetary independence restricts the capacity of monetary authorities to pursue exceedingly expansionary monetary policies (Ickes 1). Speaking of prices, fixation allows lowering inflation by preventing prices from soaring. De Nederlandsche Bank (n.pag.) suggests that price stability is the principal goal of monetary policy. If kept from going up or down, as is the case with inflation or deflation, price stability will ensure the buying capacity of a currency (De Nederlandsche Bank n.pag.). Thus, if fixed regimes control price level and stability, that is central to monetary policy, pegging has a positive impact on monetary policy. If so, pegging may be not as negative for monetary policy, as depicted by some economists reasoning governments into choosing fixation. Not only seems a negative trade impact theory fallacious, but also is the presumption of investment reduction.
The reason government may favor keeping the exchange rate fixed is its potential of reducing inflation. According to Ghosh, Ostry, Gulde, and Wolf (n.pag.), in pegging the exchange rate, a government can succeed in lowering the inflation, yet there is a dangerous possibility lest the growth of productivity reach a low rate. The stabilizing effect of the pegged rate on inflation is a product of a confidence effect, that is to say, a higher degree of confidence results in a greater willingness to keep national currency instead of foreign currencies or commodities and a discipline effect, that is, the political price of dropping the peg impels tighter policies. To a degree, the pegged rate of exchange correlates with low inflation since countries with such level of inflation are more adept in keeping the peg. Some signs point to causality in the other direction, with states opting for a pegged rate securing a lower level of inflation. Apparent is that a country with an ill-thought-out monetary policy is sure to fail to keep the exchange rate pegged for a long period. The advocates of rate fixation maintain that pegging leads to a better monetary discipline (Ghosh, Ostry, Gulde, and Wolf n.pag.).
Ghosh, Ostry, Gulde, and Wolf (n.pag.) present the numerical evidence that stems from the comparison of states that made a transition from a floating to a fixed regime and vice versa. One year after a switch, inflation was 0.6% as low as the year before the transition. Inflation intensity was 0.5% two years after pegged regime being imposed, as was the rate three years following the adoption. On the contrary, the level of the drop in money buying capacity and an increase in price rate went 3% up on the year preceding the imposition of a floating exchange regime. Two years after the transition the rate of inflation was 1.8 as high as that before the move. In three years, the level exceeded the pre-transition rate by 2.3% (Ghosh, Ostry, Gulde, and Wolf n.pag.).
Another proof makes itself seen in the case of states with different regimes of exchange rates, albeit similar volatility in nominal effective rates of currency exchange. States with the fixed rates of exchange are normally demonstrative of lower effective exchange rate variability. Seeing as how the regime of exchange rate is important for inflation, there is a distinction between states with floating and fixed rate of exchange even after controlling for nominal exchange rate variability. The fixation of the nominal exchange rate that simulates confidence influences inflation by doing more than reducing nominal exchange rate variability. Inflationary pressure can grow bigger, yet there is the possibility of it being stopped in the course of fixed exchange rates. Imposing a floating regime can send the level of inflation exploding. Fixed regimes have a positive effect on the general investment picture; however, floating rates increase the growth of productivity and GDP (Ghosh, Ostry, Gulde, and Wolf n.pag.).

Works Cited

Danmarks National Bank. “Monetary Policy.” NationalBanken.dk. n.d. n.pag. Web. 17 Apr. 2015.
De Nederlandsche Bank. “Monetary Policy – Inflation, Stable Prices, and Interest Rates.” DNB. n.d. n.pag. Web. 17 Apr. 2015.
Division of Social Sciences. “Monetary Policy under Fixed Exchange Rates.” University of California, San Diego. n.d. n.pag. Web. 17 Apr. 2015.
Econometrics Laboratory. “Chapter 19. Macroeconomic Policy and Coordination under Floating Exchange Rates.” University of California, Berkeley. n.d. 1-37. PowerPoint Presentation. Web. 17 Apr. 2015.
Ghosh, Atish R., Ostry, Jonathan D., Gulde, Anne-Marie, and Holger C. Wolf. “Does the Exchange Rate Regime Matter for Inflation and Growth?” International Monetary Fund. 1997. n.pag. Web. 17 Apr. 2015.
Ickes, Barry W. “Lecture Note on Exchange Rates Regimes, Optimum Currency areas, and the Euro.” Penn State. Department of Economics. 2002. n.pag. Web. 17 Apr. 2015.