# International Economics: Theory and Policy, v. 1.0

by Steve Suranovic

## 23.2 Monetary Policy with Fixed Exchange Rates

### Learning Objective

1. Learn how changes in monetary policy affect GNP, the value of the exchange rate, and the current account balance in a fixed exchange rate system in the context of the AA-DD model.
2. Understand the adjustment process in the money market, the Forex market, and the G&S market.

In this section, we use the AA-DD model to assess the effects of monetary policy in a fixed exchange rate system. Recall from Chapter 18 "Interest Rate Determination" that the money supply is effectively controlled by a country’s central bank. In the case of the United States, this is the Federal Reserve Board, or the Fed. When the money supply increases due to action taken by the central bank, we refer to it as expansionary monetary policy. If the central bank acts to reduce the money supply, it is referred to as contractionary monetary policy. Methods that can be used to change the money supply are discussed in Chapter 18 "Interest Rate Determination", Section 18.5 "Controlling the Money Supply".

## Expansionary Monetary Policy

Suppose the United States fixes its exchange rate to the British pound at the rate Ē$/£. This is indicated in Figure 23.1 "Expansionary Monetary Policy with a Fixed Exchange Rate" as a horizontal line drawn at Ē$/£. Suppose also that the economy is originally at a superequilibrium shown as point F with original gross national product (GNP) level Y1. Next, suppose the U.S. central bank (the Fed) decides to expand the money supply by conducting an open market operation, ceteris paribus. Ceteris paribus means that all other exogenous variables are assumed to remain at their original values. A purchase of Treasury bonds by the Fed will lead to an increase in the dollar money supply. As shown in Chapter 20 "The AA-DD Model", Section 20.5 "Shifting the AA Curve", money supply changes cause a shift in the AA curve. More specifically, an increase in the money supply will cause AA to shift upward (i.e., ↑MS is an AA up-shifter). This is depicted in the diagram as a shift from the red AA to the blue AA′ line.

Figure 23.1 Expansionary Monetary Policy with a Fixed Exchange Rate

## Discussion

This result indicates that monetary policy is ineffective in influencing the economy in a fixed exchange rate system. In contrast, in a floating exchange rate system, monetary policy can either raise or lower GNP, at least in the short run. Thus monetary policy has some effectiveness in a floating system, and central bank authorities can adjust policy to affect macroeconomic conditions within their economy. For example, if the economy is growing only sluggishly, or perhaps is contracting, the central bank can raise the money supply to help spur an expansion of GNP, if the economy has a floating exchange rate. However, with a fixed exchange rate, the central bank no longer has this ability. This explains why countries lose monetary autonomy (or independence) with a fixed exchange rate. The central bank can no longer have any influence over the interest rate, exchange rate, or the level of GNP.

One other important comparison worth making is between expansionary monetary policy in a fixed exchange rate system with sterilized foreign exchange (Forex) interventions in a floating system. In the first case, expansionary monetary policy is offset later with a contraction of the money supply caused by automatic Forex intervention. In the second case, Forex intervention leading to an expansion of the money supply is countered with contractionary open market operations. In the first case, the interest rate is maintained to satisfy interest rate parity. In the second case, the interest rate remains fixed by design. Clearly, these two situations represent exactly the same set of actions, though in a different order. Thus it makes sense that the two policies would have the same implications—that is, “no impact” on any of the economic variables.

### Key Takeaways

• There are no effects from expansionary or contractionary monetary policy in a fixed exchange rate system. The exchange rate will not change, there will be no effect on equilibrium GNP, and there will be no effect on the current account balance.
• Monetary policy in a fixed exchange rate system is equivalent in its effects to sterilized Forex interventions in a floating exchange rate system.

### Exercise

1. Suppose that Latvia can be described with the AA-DD model and that Latvia fixes its currency, the lats (Ls), to the euro. Consider the changes in the exogenous variable in the left column. Indicate the short-run effects on the equilibrium levels of Latvian GNP, the Latvian interest rate (iLs) , the Latvian trade balance, and the exchange rate (ELs/€). Use the following notation:

+ the variable increases

the variable decreases

0 the variable does not change

A the variable change is ambiguous (i.e., it may rise, it may fall)