1. What does it mean for a country to fix its exchange rate?
2. We use the terms fixed or pegged exchange rate to refer to any system in which a monetary authority announces buying and selling rates for its currency in terms of a foreign currency and promises to trade in unlimited amounts at that rate. The buying and selling rates could be the same, but in most systems they differ, a circumstance that gives rise to (usually narrow) bands within which even "fixed “exchange rates, in our definition, may fluctuate
A. Explain the nature of the bands the Bretton Woods system set up to allow exchange rates to fluctuate. In the postwar Bretton Woods system, dollar exchange rates could fluctuate by ± 1 percent around declared central parities, and for most EMS currencies before August 1993, bilateral rates could move by ±2.25 percent. Obviously, the precise dividing line between a fixed rate in the foregoing sense, and a floating one is not clear-cut: as the official buying and selling rates move farther apart, the exchange-rate arrangement approaches a free float. B. How would you dene a "crawling peg?" Why can this be thought of as a type of fixed exchange rate?
One variation on fixed rates that is common among high-inflation developing countries is the "crawling peg," in which the government announces a schedule of small, discrete devaluations. The idea is to prevent inflation differentials from cumulating, thereby necessitating a single large devaluation. As we shall see, however, crawling pegs share many of the basic problems of garden-variety fixed rates. This can be thought of as a type of fixed exchange rate because it allows the currency to move within a band of fixed rates. This occurs because if it was truly fixed than there would be an instant depreciation or appreciation of currency instead of risking a rapid devaluation, currency can now be slowly devalued or appreciated to a more appropriate exchange rate with the crawling peg.
3. Why do the authors argue for the impotence of monetary policy under a fixed exchange rate?
4. The fundamental problem with a fixed exchange rate is that the government must be prepared to forgo completely the use of monetary policy for stabilization purposes. Consider the problem faced by a country that is hit by a sudden and permanent fall in the demand for its exports. Even in a flexible-price world, such a shock would make the country worse off. But with a fixed exchange rate and temporary rigidities in nominal prices and wages, the harm is magnified. With no way for the relative prices of exports and imports to adjust in the short run, domestic employment and output must fall.
A. Why might fiscal policy not be a good substitute for monetary policy? fiscal policy responds sluggishly and may entail undesirable intergenerational distributions, political side payments and dead-weight costs. Commercial policies such as tariffs imply their own efficiency costs, are (rightly) restricted by international agreement, and invite relation by trading partners.
B. How does capital mobility contribute to the impotence of monetary policy?
The stumbling block is the combination of a fixed exchange rate and open capital markets. If the exchange rate cannot change and if capital is mobile, then the domestic nominal interest rate must equal the foreign nominal interest rate.2 But this obviously implies that domestic interest rates are determined abroad, not by domestic monetary policy . Any attempt to expand the money supply—for example, by an open-market purchase of domestic securities would leave people holding more money than they desire at the prevailing, foreign, rate of interest. Rather than bidding the interest rate down, as in a closed-economy model or as would happen under a floating exchange rate, agents simply sell their excess money holdings to the home central bank for foreign currency at the fixed exchange rate.
C. What is meant by sterilized