If a country adopts a fixed exchange rate policy, the exchange rate is the target of monetary policy. Monetary policy cannot pursue an inflation target or an output target at the same time as it pursues an exchange rate target. Nor can it set either interest rates or money supply growth rates independently.
With a fixed exchange rate, interest rates must be set as needed to maintain the exchange rate when capital mobility is high. Indeed, the higher international capital mobility is, the less is the scope for independent monetary policy. This is what we mean when we say fixed exchange rates eliminate monetary policy sovereignty. The central bank cannot follow an independent monetary policy.
Fiscal policy with fixed exchange rates
A fixed exchange rate and perfect capital mobility undermine the scope for monetary policy, but maintain the effectiveness of fiscal policy.
In a closed economy, in the short run, fiscal expansion raises output. Under a monetary policy rule with the interest rate as the policy instrument, as long as output is less than potential output, the central bank supports the increase in output by maintaining interest rates and increasing the money supply as output expands. However, at outputs equal to or greater than potential output, central banks raise interest rates to crowd out the effect of fiscal expansion.
In an open economy with fixed exchange rates, monetary policy adjusts passively to keep the interest rate fixed in order to defend the exchange rate. Interest rates do not change to support fiscal policy or moderate the effect of fiscal policy. Hence, any fall in domestic demand can be offset by a fiscal expansion to help restore potential output. If the change in domestic demand is the only reason that the current account balance departed from equilibrium, this fiscal expansion will also restore the current account balance.
Fiscal policy is potentially an important stabilization policy under fixed exchange rates. It helps to compensate for the fact that monetary policy can no longer be used. Automatic fiscal stabilizers play this role. Discretionary changes in government spending or taxes are useful only if fiscal policy can react quickly to temporary shocks. In some political systems, such as in Canada, this is feasible. In others, such as in the United States, where Congress and the President may be from different parties and budget decisions are more protracted, rapid changes in fiscal policy are more difficult.
In times of prolonged recession, discretionary fiscal policy can contribute importantly to a return to potential output, provided it is not constrained by high public debt ratios. With interest rates tied to the exchange rate, financing a fiscal expansion does not push rates up to crowd out private sector expenditure; nor does the recovery of the economy result in rising rates. Indeed, fiscal policy is the only effective domestic demand management tool available.
Unfortunately, high public debt ratios and concerns about the default risk of sovereign debt cause problems for fiscal policy. This is the current situation in Europe. Fiscal expansion is impossible if financial markets are unwilling to buy more sovereign debt from economies in recession that already have high debt ratios. On the other hand, fiscal austerity to control deficits and debt ratios makes recessions worse and may even raise already high debt ratios as GDP and government net revenue fall. The euro fixes exchange rates within Europe and precludes stimulus from currency depreciation. Neither domestic fiscal nor monetary policy offers a solution.
Things are further complicated because many European countries have similar economic and financial difficulties. Canadian success with fiscal austerity and adjustment in the 1990s came from a very different economic environment. Monetary policy and exchange rate depreciation provided stimulus. Strong economic growth in major trade partners provided further stimulus through export growth. These conditions are clearly not met in Europe and coordinated fiscal austerity to address sovereign debt issues has been described as an 'economic suicide pact'.
This chapter extended the discussion of short-run macroeconomic performance and policy by covering in more detail the importance of international trade, capital flows, and exchange rates for the design, coordination and effectiveness of monetary and fiscal policies. The next chapter introduces the theory of economic growth that explains the long-run growth in potential output based on growth in the labour force, growth in the capital stock and changes in productivity based on advances in technology.