Answer to Question #72603 in Macroeconomics for Agrita singh

Question

In an open economy with fixed exchange rate, the government does not have autonomy in monetary policy. Do you agree with this statement? Justify your answer.

Answer 1

I completely agree with the statement.
Fixed exchange rate works as a constraint in making the monetary policy effective. An increase in money supply leads to decrease in the interest rate domestically, and then foreign investments become more attractive which further leads to increase in demand for the foreign currency due to which domestic currency leads to depreciates if there is a floating exchange rate system. In the fixed exchange rate regime, the central bank must supply the increased demand of foreign currency which leads to the deficit in BOP and will purchase its own domestic currency and this purchase will counterweight the rise in money supply earlier by the central bank, so the government would not increase the money supply.