David K.H. Begg, Gianluigi Vernasca-Economics-McGraw Hill Higher Education (2011)

25. l Fixed exchange rates
A shock from abroad
Suppose next there is a shock to foreign demand, raising demand for net exports. The current account (X -Z)
moves into surplus. Aggregate demand shifts up, and the economy has a boom and a current account
surplus. It adds to forex reserves.
In a closed economy, the boom induces a rise in interest rates that eventually returns aggregate demand to
potential output. In an open economy with a fixed exchange rate, interest rates remain constant. The boom
gradually bids up inflation and reduces competitiveness, reversing the original rise in net exports. When
prices rise enough to restore current account balance, aggregate demand reverts to its original level and
internal balance is also restored. 1 Thus a temporary period of extra inflation permanently raises the price
level, permanently changing the real exchange rate.
Sovereignty and monetary union
II
In 1999 Chicago professor Robert Mundell won the Nobel Prize
for helping invent open economy macroeconomics. He was the
first to realize that openness in product and factor markets may create powerful
pressures for monetary union. He also showed what it would be like for a
small country to try to hang on to monetary sovereignty when international
capital mobility is high.
The figure below shows a pegged exchange rate. The UK pegged the pound during
its short membership of the ERM in 1990-92. IS is the usual relationship between
interest rates and output consistent with goods market equilibrium. A small country
can peg its exchange rate only by matching the foreign interest rate r*. We show this as
a horizontal line. The money supply adjusts to make sure this is always the domestic
interest rate. Initial equilibrium is at A.
As in Figure 25.2, any attempt to change the money supply, and hence interest rates,
causes an immediate capital inflow or outflow on the financial account until the
money supply and interest rates are restored to r*. For a small open
economy with a pegged exchange rate, monetary policy is powerless.
A fiscal expansion shifts IS to IS'. There is a big short-run effect on
output, from Y to Y', since interest rates cannot rise to dampen the
expansion. Monetary policy is forced to create additional money
supply to accommodate the extra money demand when output rises.
We can think of the horizontal line for interest rates as being achieved
by a shift in the implicit LM schedule from LM to LM'. In fact, we
may as well regard the horizontal line as the LM schedule itself.
Y* is potential output. If a demand shock shifts IS to IS', potential
output is not restored by induced changes in interest rates as in a
closed economy. Interest rates remain at r*. Rather, higher prices
-
c
..
Perfect capital mobility
undermines monetary
sovereignty. If interest rates
are set to maintain the pegged
exchange rote, they cannot be
set independently to influence
the domestic economy.
Picture: The€ l coin
©Jenny Zhou I Dreamstime.com
Y* Y'*
Output
reduce competitiveness and hence shift IS' leftwards. Under a pegged exchange rate, induced changes in IS
schedules restore output to full capacity. If this takes too long, fiscal policy must shift IS' back to IS.
1 During the boom, the current account surplus adds to foreign assets, which may therefore be a little higher in the new equilibrium
than in the original equilibrium. If so, restoring current account balance does not quite restore the original level of the trade balance.
For internal balance, potential output equals domestic absorption plus net exports. If net exports have changed a little, so has domestic
absorption. Such details belong in a more advanced course. The basic adjustment mechanism remains as described in the text.
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