Analyzing Monetary and Fiscal Policies with Fixed Exchange Rates

When countries manage their economies in an interconnected global financial system, they face fundamental choices about how to structure their economic policies. Among the most important decisions is choosing an exchange rate regime and understanding how this choice affects the power of monetary and fiscal policy tools. Under a fixed exchange rate system, something remarkable happens: fiscal policy becomes extraordinarily powerful while monetary policy loses almost all its effectiveness. This dynamic reveals deep insights about how open economies function and the trade-offs governments must navigate.

Why fiscal policy becomes highly effective under fixed exchange rates 🔗

When a government operates under a fixed exchange rate regime, expansionary fiscal policy becomes remarkably powerful as a tool for managing aggregate demand. To understand why, imagine a government that increases spending on infrastructure projects or cuts taxes to boost consumer purchasing power. This fiscal expansion shifts the IS curve rightward, signaling increased demand for goods and services in the economy.

Here’s where things get interesting. As aggregate demand rises, so does national income, which in turn increases the demand for money. With more people and businesses wanting to hold cash for transactions, domestic interest rates begin to climb. In a closed economy, this rising interest rate would normally dampen the fiscal expansion by crowding out private investment. But in an open economy with free capital mobility, higher interest rates attract foreign investors like bees to honey.

International investors, spotting the opportunity for higher returns, rush to buy domestic assets. They need domestic currency to make these purchases, so they sell foreign currency and buy the home currency on foreign exchange markets. This creates upward pressure on the domestic currency’s value and generates a balance of payments surplus.

Under a floating exchange rate, the currency would simply appreciate until equilibrium restored itself. But with a fixed exchange rate, the central bank cannot allow the currency to strengthen beyond its pegged value. To maintain the fixed parity, the central bank must intervene by buying foreign currency and selling domestic currency. When the central bank sells domestic currency, it increases the money supply circulating in the economy. This monetary expansion shifts the LM curve rightward, which reinforces the original fiscal stimulus rather than offsetting it.

The result? The fiscal expansion gets a double boost-first from the direct increase in government spending or tax cuts, and second from the monetary expansion that occurs automatically as the central bank defends the fixed exchange rate. Output rises substantially, and the fixed exchange rate prevents any crowding out through currency appreciation. This makes fiscal policy the primary tool for demand management under fixed exchange rates.

The ineffectiveness of monetary policy under fixed rates 🔗

While fiscal policy flourishes under fixed exchange rates, monetary policy faces an entirely different fate. Attempting to use monetary policy under fixed exchange rates is like trying to fill a bucket with a hole in the bottom-any effort is quickly undone by the system’s own logic.

Consider a central bank that attempts expansionary monetary policy by increasing the money supply. Initially, this monetary expansion shifts the LM curve rightward, lowering the domestic interest rate. Lower interest rates reduce the return on domestic assets compared to foreign assets, prompting investors to move their capital abroad in search of better returns. They sell domestic currency to buy foreign currency, creating downward pressure on the domestic currency’s value.

Here’s the catch: to defend the fixed exchange rate, the central bank must intervene by selling foreign reserves and buying back domestic currency. When the central bank purchases domestic currency from the market, it reduces the money supply-the exact opposite of what the monetary expansion was trying to achieve. The LM curve shifts back to its original position, completely reversing the initial monetary stimulus.

The attempted monetary expansion is entirely offset, leaving output, interest rates, and the exchange rate unchanged. The central bank’s efforts cancel themselves out through the automatic balance of payments adjustment. This is why monetary policy is essentially powerless as a tool for managing aggregate demand under fixed exchange rates with perfect capital mobility.

A real-world example: the UK’s struggle in 1992 🔗

The limitations of monetary policy under fixed rates became painfully clear during the 1992 European Exchange Rate Mechanism crisis. Britain attempted to maintain a fixed exchange rate against the German mark while experiencing free capital movement. When markets believed the pound was overvalued, investors began selling pounds, putting downward pressure on the currency.

To defend the peg, the British government raised interest rates dramatically-at one point reaching 15 percent. These sky-high rates were devastating for an economy already struggling with recession. The government faced an impossible choice: maintain the fixed exchange rate and sacrifice domestic economic recovery, or abandon the peg to regain monetary policy autonomy. Britain ultimately chose to leave the Exchange Rate Mechanism, allowing interest rates to fall and spurring economic recovery. This episode illustrates why countries cannot simultaneously maintain a fixed exchange rate, free capital flows, and independent monetary policy.

Understanding the endogeneity of money supply 🔗

Under fixed exchange rates with perfect capital mobility, something fundamental changes about the nature of money in the economy: the money supply becomes endogenous. This means the central bank no longer truly controls the quantity of money circulating in the economy.

In a floating exchange rate system, the central bank can set the money supply as an independent policy variable. But under fixed rates, the money supply adjusts automatically and passively based on the balance of payments. When the country runs a balance of payments surplus-as happens during fiscal expansion or when foreign investors are attracted by domestic conditions-the central bank must buy foreign currency to prevent appreciation. This intervention increases the domestic money supply.

Conversely, when the country experiences a balance of payments deficit, the central bank must sell foreign reserves to prevent depreciation, which reduces the money supply. The central bank’s interventions to maintain the fixed exchange rate directly determine changes in the money supply, making it an endogenous variable rather than a policy tool. This has profound implications: the central bank cannot simultaneously target both the exchange rate and the money supply. By committing to a fixed exchange rate, it necessarily surrenders control over monetary conditions.

The impossible trinity: understanding the fundamental constraint 🔗

The experiences described above point to a fundamental constraint in international macroeconomics known as the impossible trinity or policy trilemma. This principle states that a country cannot simultaneously achieve three desirable goals: a fixed exchange rate, free capital mobility, and an independent monetary policy. A country must choose any two of these three objectives, but having all three together is impossible.

Think of it as a triangle where each corner represents one policy goal. You can occupy any edge of the triangle-combining two goals-but you cannot occupy all three corners at once. Under fixed exchange rates with free capital mobility (one edge of the triangle), the country must sacrifice monetary policy independence. The central bank cannot set interest rates to address domestic economic conditions because interest rates must align with foreign rates to maintain the fixed exchange rate.

Why the trilemma exists: the mechanism 🔗

The trilemma arises from the logic of international arbitrage. If a country maintains a fixed exchange rate and allows free capital movement, any difference between domestic and foreign interest rates creates a profit opportunity. Investors will borrow in the low-interest-rate country and lend in the high-interest-rate country. These capital flows continue until interest rates equalize across countries, or until the exchange rate adjusts to reflect the interest rate differential.

With a fixed exchange rate, the only way to prevent these destabilizing capital flows is either to give up monetary independence (keeping domestic interest rates in line with foreign rates) or to impose capital controls (restricting the free movement of money across borders). Countries throughout history have chosen different positions on the trilemma triangle depending on their priorities and circumstances.

Historical choices and modern dilemmas 🔗

During the classical gold standard era before World War I, countries maintained fixed exchange rates (their currencies were convertible to gold at fixed rates) and allowed free capital mobility, but sacrificed monetary policy autonomy. The post-World War II Bretton Woods system chose fixed exchange rates and monetary independence, necessitating capital controls to prevent destabilizing flows.

Today, most advanced economies have chosen floating exchange rates and free capital mobility, allowing them to maintain independent monetary policies. However, some countries still opt for different combinations. China, for example, has at various times maintained a managed exchange rate and monetary policy autonomy by imposing capital controls, though this approach has become increasingly difficult to sustain as financial markets have grown more sophisticated.

The Eurozone represents yet another approach: member countries have fixed exchange rates relative to each other (by adopting a common currency), free capital mobility within the union, but must accept monetary policy set by the European Central Bank rather than having independent national policies. This arrangement has created tensions, especially during economic crises when different countries might benefit from different monetary policies.

What do you think? Given the trade-offs inherent in the impossible trinity, which combination of policies would be most appropriate for a developing economy trying to attract foreign investment while maintaining some control over its domestic economy? How might technological advances in finance and the rise of cryptocurrency affect the relevance of the impossible trinity in the future?

References

1. https://saylordotorg.github.io/text_international-economics-theory-and-policy/s26-03-fiscal-policy-with-fixed-excha.html
2. https://saylordotorg.github.io/text_international-economics-theory-and-policy/s26-policy-effects-with-fixed-exch.html
3. https://www.economicshelp.org/blog/glossary/policy-trilemma-the-impossible-trinity/
4. https://en.wikipedia.org/wiki/Impossible_trinity