Tuesday, March 31, 2009

Do Fixed or flexible Exchange rates provide for greater "discipline" on the part of policymakers?(1)

A point made in favor of fixed exchange rates is that such a system provides for the "discipline" needed in economic policy to prevent continuing inflation.that is ,in a fixed-rate system,there should be no tendency for greater inflation to occur in one country than in the world as a whole .Consider a country with a balance -payment (BOP) deficit .if the cause of the deficit is a more rapid inflation than that in trading partners,then the country is authorities will need to apply anti-inflationary policy to protect the country is international reserve position .the fixed-rate system virtual forces this type of policy action ,because failure to do so will lead to eventual elimination of the country is international reserves if the automatic adjustment mechanism takes considerable time . what about the situation in BOP surplus country? given the objective of a fixed exchange rate , the forces working in the opposite direction from that for a deficit country are set into motion .Accumulation of foreign exchange reserves (which may be difficult to sterilize )will expand the money supply.This enhancement of the money supply will drive the interest rate downward ,increase aggregate demand and prices,increase private purchases of goods and foreign financial assets,and thus eliminate the surplus.

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