[Joseph_E._Stiglitz,_Carl_E._Walsh]_Economics(Bookos.org) (1)

768 ∂ CHAPTER 34 THE INTERNATIONAL FINANCIAL SYSTEM
constant. Thus, to maintain a fixed exchange rate, the Bank of Canada (Canada’s central
bank) must ensure that it keeps the Canadian interest rate equal to the U.S. interest
rate. If the Bank of Canada tries to reduce interest rates slightly, perhaps in an
attempt to stimulate Canadian investment spending if Canada is in a recession, foreign
investors will sell Canadian dollars as they take their capital out of the country to earn
higher yields in the United States. To prevent the exchange rate from changing, the
Bank of Canada would have to push interest rates back up. Similarly, any attempt to
raise interest rates would attract a capital inflow that would push the value of the currency
up. To keep the exchange rate at its pegged rate, the central bank would have to
lower interest rates back down. By the same argument, if the Federal Reserve increases
the U.S. interest rate, the Bank of Canada will have to follow suit and raise the Canadian
interest rate if it wishes to maintain its fixed exchange rate. In a small open economy
under a fixed exchange rate system with perfect capital mobility, the central bank must keep
the interest rate equal to the foreign interest rate. The country cannot run an independent
monetary policy.
This result can help us understand three important recent episodes. First, it
helps explain why the European economies decided to adopt a common currency
once they integrated their economies and fixed their exchange rates. No individual
country in the monetary union can run an independent monetary policy, so the
members of the union have given up their own national currencies and delegated
monetary policy for the entire union to the European Central Bank.
Second, it helps us understand why in 1992 the United Kingdom dropped out of
the European Monetary System, a system of fixed exchange rates that preceded
the Economic and Monetary Union. The United Kingdom was in a recession, and
many economists argued for interest rate cuts to help expand aggregate expenditures.
As long as the United Kingdom wanted to maintain its fixed exchange rate, it could
not cut interest rates. Because speculators thought the country might drop out of the
European Monetary System and cut interest rates, they expected the pound to
depreciate. This expectation shifted the demand curve for pounds to the left; and
to offset this downward pressure on the pound exchange rate, the Bank of England
had to keep its interest rates higher than those in Germany just when domestic factors
called for interest rate cuts. Finally, the system collapsed; the United Kingdom
dropped out of the European Monetary System, cut its interest rates, and let the
pound depreciate against the other European currencies.
Third, the loss of monetary control under a fixed exchange rate system explains
why countries that have experienced high inflation rates often decide to fix their
exchange rate as part of a disinflation policy. In fact, while the loss of an independent
monetary policy is one of the chief arguments against a fixed exchange rate
system, paradoxically it is also one of the chief arguments in favor of this system for
countries that have a history of high inflation and bad monetary policy.
Pegging the nominal exchange rate forces a high-inflation country to bring its
own inflation rate down. If it does not, its exports will become more and more
expensive as its price level rises faster than that of other countries (a real appreciation).
As its net exports decline, the demand for its currency, at the fixed
exchange rate, falls. To maintain the fixed exchange rate, the central bank must
raise interest rates. Doing so reduces aggregate expenditures, reducing output
and ultimately inflation.