How do flexible and fixed exchange rate affect the monetary policy and fiscal policy

 Flexible exchange rate:

A flexible exchange-rate system is a monetary system that allows the exchange rate to be determined by supply and demand.

Affect of flexible exchange rate on monetary and fiscal polocy;

Monetary policy

With flexible exchange rates, monetary policy causes changes in both interest rates and exchange rates. Net international capital flows link exchange rates and changes in domestic interest rates when exchange rates are flexible. Given the exchange rate expected in the long run, higher interest rates in the short to medium run cause a capital inflow, an increased supply of foreign exchange on the foreign exchange market, which lowers the exchange rate, er.

Conversely, lower domestic interest rates relative to international rates cause a rise in the exchange rate, er.

As a result, current monetary policy and expected future monetary policies have strong effects on the nominal exchange rate and the international competitiveness of the domestic economy and AD. Changing current interest rates for a short time will have only small exchange rate effects. However, a credible change in monetary policy for a sustained period will cause a large and persistent change in current exchange rates, an important factor in the monetary transmission mechanism. This can have large short-run effects on the real economy.

As a result, in an open economy with flexible exchange rates, monetary policy affects aggregate demand not just through the effects of interest rates on consumption and investment.

Fiscal policy

With flexible exchange rates, but without monetary policy accommodation or support, the effect of interest rate changes on exchange rates and competitiveness undermines the power of fiscal policy to manage aggregate demand.

Suppose the government undertakes a fiscal expansion, raising government expenditures or lowering taxes or some combination of the two: Aggregate demand increases. When monetary policy targets an inflation rate based on either an interest rate rule or a money supply rule, the expansion in AD caused by fiscal policy changes the economic fundamentals on which the central bank's policy had been set and induces the bank to raise interest rates. The higher interest rates cause a net capital inflow and an increased supply of foreign exchange on the foreign exchange market, and the nominal exchange rate falls. A fall in the nominal foreign exchange rate lowers the real exchange rate. International price competitiveness (as measured by the real exchange rate) is reduced and net exports fall, offsetting the expansionary effects of the change in fiscal policy. With flexible exchange rates monetary policy targeted to the inflation rate dominates fiscal policy as a tool for aggregate demand management.

Fixed exchange rate:

A fixed exchange rate is a regime applied by a government or central bank that ties the country's official currency exchange rate to another country's currency or the price of gold. The purpose of a fixed exchange rate system is to keep a currency's value within a narrow band.

Affect of fixed exchange rate on monetary and fiscal policy;
Monetary policy
• A monetary policy (change in MS) has no effect on GNP or the exchange rate in a fixed exchange system. As such, the trade balance, unemployment, and interest rates all remain the same as well. Monetary policy becomes ineffective as a policy tool in a fixed exchange rate system.



Fiscal policy

• Expansionary fiscal policy in a fixed exchange rate system will cause an increase in GNP, no change in the exchange rate (of course), and a decrease in the current account balance.

• Contractionary fiscal policy in a fixed exchange rate system will cause a decrease in GNP, no change in the exchange rate (of course), and an increase in the current account balance.