Fixed Exchange Rate

fixed exchange rate – where countries maintain a fixed exchange rate

• keeps exchange rate constant in terms of some foreign currency
• peg – keeps currency constant relative to another certain currency
  • not entirely fixed >> could still change (devaluation/revaluation), but very rarely
• crawling peg – uses a predetermined rate of depreciation against the pegged currency
  • in cases where inflation rates are different
  • w/ or w/o pegging: i_t = i*_t - (E_t+1-E_t)/E_t
  • i_t = i*_t under fixed exchange rates (domestic interest equals foreign interest)
  • central bank can’t use monetary policy under fixed exchange (M/P = Y L(i*) must stay true)

fiscal policy under fixed exchange rates – assume fiscal expansion

• central bank can’t let currency appreciate
  • must increase money supply (money demand grows as output is increased by fiscal expansion
  • bank adjusts so that interest doesn’t change (so exchange rate still stays constant)
• fiscal policy >> monetary accommodation
  • output actually increases more under fixed exchange rate than flexible exchange rate
• fixed exchange rate >> gives up monetary policy, gives up control over interest rate
  • w/ only fiscal policy, cannot avoid increasing trade deficits when getting economy out of recession (w/ fiscal expansion)

• output increases w/o change in exchange rate (since interest fixed) >> trade deficit grows
• initially fiscally shifts, but money market must accomodate to keep the interest at the same original level