Lec22-_Ch20-II_-ECON2123-LI-fa13-stu

Some countries operate under fixed exchange rates

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Unformatted text preview: tes. These countries maintain a fixed exchange rate in terms of some foreign currency. Some peg their currency to the dollar. Some countries moved further, agreeing to adopt a common currency, the euro, in effect, adopting a “fixed exchange rate.” 11 4-2 FIXED EXCHANGE RATES (20-5) Pegging the Exchange Rate and Monetary Control The interest parity condition is: (1 i) t (1 * i )£ t E E t I e t1 Pegging the exchange rate turns the interest parity relation into: (1 i) t (1 * i) t i t i * t In words: Under a fixed exchange rate and perfect capital mobility, the domestic interest rate must be equal to the foreign interest rate. 4-2 FIXED EXCHANGE RATES (20-5) Pegging the Exchange Rate and Monetary Control Increases in the domestic demand for money must be matched by increases in the supply of money in order to maintain the interest rate constant, so that the following condition holds: (because now i=i*) M Y L (i ) * P Let’s summarize: Under fixed exchange rates, the central bank gives up monetary policy as a policy instrument. TRILEMMA IN INTERNATIONAL ECONOMICS Impossible trinity! 1. 2. 3. A fixed exchange rate. Free capital movement (absence of capital controls). An independent monetary policy (monetary autonomy) a: hong kong b:us c:china 14 4-2 FIXED EXCHANGE RATES (20-5) Fiscal Policy under Fixed Exchange Rates Figure 20 – 5 The Effects of a Fiscal Expansion under Fixed Exchange Rates Under flexible exchange rates, a fiscal expansion increases output from YA to YB. Under fixed exchange rates, output increases from YA to YC . The central bank must accommodate the resulting increase in the demand for money. 4-2 FIXED EXCHANGE RATES (20-5) Fiscal Policy under Fixed Exchange Rates There are a number of reasons why countries choosing to fix its interest rate appears to be a bad idea: By fixing the exchange rate, a country gives up a powerful tool for correcting trade imbalances or changing the level of economic activity. By committing to a particular exchange rate, a country also gives up control of...
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