Forex Trading Question for Experts and Beginner

Saturday, June 18, 2011

Why does a Fixed Exchange Rate prevents a country from using domestic monetary policy for macro stability?

Sure the country can impose/abolish capital controls or restrict/loosen FX trade. Even more intuitively, it can also use open-market operations for ANY reason.

The point, however, is that you have a numerical target for the FX rate. Open-market operations, changes in capital controls, etc., of course move the FX rate. A fixed-exchange rate regime gives up domestic monetary policy independence. You only buy or sell your currency to keep the FX rate fixed. If you buy or sell your currency for any other reason, you’ll inadvertedly move the FX rate away from the target, conflicting with the goal of a fixed FX rate.

In others words, in most reasonable models, there is only one stance of monetary policy (where you can think of the “stance of monetary policy” as an aggregate of all the monetary policy instruments at your disposal) consistent with a fixed exchange rate. This stance is consistent with ONE fixed exchange rate, but at the same is consistent with ONE inflation rate, ONE level of aggregate economic activity, ONE short-term interest rate, etc.


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