Question

Why is monetary policy less effective with fixed exchange rates than with flexible?

Answer 1

Fixed exchange rate system does not allowed the exchange rate to deviate from the pegged value. This implies that whenever the exchange rate differs from its fixed value, Central Bank of the country has to intervene in the foreign exchange market and conduct open market operations of buying and selling foreign currencies and domestic currency respectively, thereby losing authority over the monetary policy. Under flexible exchange rate there is no such commitment towards maintaining effect value of the exchange rate due to which Central Bank has autonomy over the monetary policy.

Take for example the case when the central bank increases the money supply in order to boost the aggregate demand. This decreases the rate of interest, increasing net capital outflow and depreciating the currency. Because exchange rate is now reduced from its pegged value, Central Bank has to reverse its decision of increasing the money supply by decreasing it. This is done in order to appreciate the depreciated currency and maintain the exchange rate at its fixed value. this shows that monetary policy loses its autonomy under fixed exchange rate.