With a fixed exchange rate and perfect capital
mobility, the domestic interest rate must match foreign interest
rates to prevent massive capital flows and allow equilibrium in the forex
market. Monetary sovereignty is then lost. Monetary policy
cannot be used independently to control the domestic economy.
A fall in domestic demand causes a fall in output and
a decline in prices. Unlike a closed economy, monetary policy cannot respond
by cutting interest rates. Rather, the fall in prices boosts competitiveness
and raises aggregate demand. When internal balance is restored, there is now
a current account surplus. This generates greater wealth, raising domestic
demand again. After a temporary boom to raise prices and reduce excess competitiveness,
internal and external
balance can be restored.
A fall in export demand generates a slump, lower prices
and higher competitiveness that restores internal and external balance. No
subsequent boom is then required.
In the short run, fiscal policy is a powerful tool under fixed exchange
rates. Fiscal expansion no longer bids up domestic interest rates in the short
run. Output expansion is accompanied by a rise in the money supply to maintain
interest rates at the world level.
A devaluation is a fall in the value of the fixed exchange
rate. With sluggish price adjustment, it raises competitiveness and aggregate
demand. With spare resources, output rises. But at potential output, net exports
can rise only if domestic absorption is cut by tighter fiscal policy.
In the long run, devaluation is unlikely to have much effect. Changing
one nominal variable merely leads to off setting changes in other nominal
variables. In passing on higher import prices and seeking cost-of-living wage
increases, firms and workers offset the competitive advantage of devaluation.
But devaluation may speed up adjustment to a shock that requires a permanent
change in competitiveness to restore internal and external balance.
Under floating exchange rates, the long-run level of the
nominal exchange rate achieves external balance, given prices at home and
abroad. In the short run, the exchange rate adjusts to prevent massive flows
on the capital account.
The exchange rate must begin at a level from which the anticipated convergent
path to its long-run equilibrium continuously provides capital gains or losses
to offset expected interest rate differentials, thus equating the expected
return on lending at home and abroad.
Under floating exchange rates, monetary policy is a powerful short-term
tool. The belief that interest rates will be higher for some time induces
a sharp appreciation of the exchange rate, so that it can then credibly promise
capital losses to off set high interest rates. With sluggish price adjustment,
the initial appreciation of the nominal exchange rate causes a sharp fall
in
competitiveness. This reduction in demand for net exports reinforces other
effects of high interest rates in reducing aggregate demand.
Fiscal policy is a weaker tool under floating exchange rates. Fiscal expansion
induces a boom and higher interest rates. The latter induce an exchange rate
appreciation that crowds out some net exports, reinforcing domestic crowding
out of consumption and investment.
The actual path of the UK nominal exchange rate reflects changing beliefs
about the future course of domestic and foreign interest rates, and about
the eventual level of the exchange rate in longrun equilibrium. The latter
depends on beliefs about the eventual price level at home and abroad, but
also on supply shocks such as resource discoveries.
