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October 17, 2006
Fixed Exchange Rates
The government devotes monetary policy to holding the exchange rate fixed.
We start with the basic model.
An increase in foreign income causes an expansion. An increase in p then returns the equilibrium to the initial point.
McCallum describes the automatic changes in the money supply caused by imposition of a fixed exchange rate. An alternative view is that the government could engage directly in domestic open market operations.
With a fixed exchange rate, fiscal policy is effective in increasing y if it is below full output and monetary policy is not.
The other two options are to do nothing (letting price adjustments increase y) and to devalue.
A common scenario is an IS curve drifting to the left (because of investment declines, for example). The central bank spends foreign exchange reserves to defend the exchange rate, but at some point resorts to devaluation to get back to full output. We really cannot ignore the expectations terms in thinking about this case. The effects of abrupt, large changes in the exchange rate are also an important issue.
With a fixed exchange rate enforced by a common currency, there simply is no LM curve.
Posted by bparke at October 17, 2006 03:27 AM