Question

Efforts to stimulate the economy using expansionary monetary policy are ineffective under a fixed exchange rate system, but can be effective under a floating rate system. Explain in some detail.

Answer 1

Under a fixed exchange rate system, when central bank applies expansionary policy and reduces the rates to increase the consumption and investment spending. But, at the same time, the local currency will depreciate and it will put pressure upon the fixed exchange rate to change. For this purpose, rates, will increase and or supply of foreign currency will also be increased by the central bank. This reverse action, will discourage the spending and expansionary monetary policy will be ineffective.

In contrast to it, when there is a flexible exchange rate system, when central bank applies expansionary policy and reduces the rates to increase the consumption and investment spending, then economy gets higher money supply as well to support the monetary policy objective. It will help increase the aggregate demand and monetary policy will become effective.

Hence, it is the type of exchange rate system that also decides the effectiveness of the monetary policy.