20.1 Monetary policy with fixed exchange rates

With fixed exchange rates, an expansion of the domestic credit stock (expansive monetary policy) does not change anything in the medium term except the composition of the money supply. Any change in domestic credits is ultimately offset by a reverse change in foreign exchange reserves via the foreign exchange market. If, after an increase in domestic credit stock DC and thus also Ms, the return of the money supply Ms to the level of equilibrium is initiated, it is called sterilization. The necessity to keep the exchange rate stable ultimately leads to a forced sterilizationof any monetary policy measure that is not aimed at the compensation of other shocks. The following graph illustrates this problem.

The slider allows a monetary policy measure to be displayed. In the case of an expansive monetary policy, the money supply is increased and interest rates fall in order to sell the increased money supply on the market. Thus, the money demand curve (middle graph) shifts upwards. With flexible exchange rates, the exchange rate would adjust in the short term by devaluing to S1 and the price level would rise. In order to maintain the fixed exchange rate, the central bank must counteract the devaluation pressure. In the model, the only way to do so, is by intervening in the foreign exchange market, i.e. it sells foreign exchange reserves for its own money in order to reduce the supply of its own currency (money in the central bank balance sheet is removed from the normal economic cycle) and to keep the price (= exchange rate) stable. In the process, the foreign exchange reserves decrease. If these are at 0, the government can no longer support the currency and the fixed exchange rate regime collapses.

If nevertheless the money supply is supposed to remain increased (for economic policy reasons), the outflow of foreign exchange must be constantly balanced by continuous printing of money. This creates a perpetual (growing), unstable imbalance with a continuous loss of foreign exchange reserves. If the ratio of imbalance and reserves becomes too unfavorable, a currency crisis occurs. Expansive monetary policy only works in the short term, if at all.

(c) by Christian Bauer
Prof. Dr. Christian Bauer
Chair of monetary economics
Trier University
D-54296 Trier
Tel.: +49 (0)651/201-2743
E-mail: Bauer@uni-trier.de
URL: https://www.cbauer.de