How Does Monetary Policy Work When Exchange Rates Are Fixed?

by W D Adkins

Fluctuations in currency exchange rates can be annoying and sometimes expensive. You might find an imported product you want has jumped in price or that you get fewer dollars back for currency you bought for a vacation trip. It’s tempting to think fixed exchange rates would make things much simpler. A government can alter its monetary policy to enforce a stable price in relation to anther currency. However, doing so usually leads to long-term problems.

History

In the aftermath of World War II, nations around the world created a currency exchange structure known as the Bretton Woods system. World currencies were tied to the U.S. dollar, which in turn was based on gold. By the late 1960s, it became clear that this had the effect of distorting the exchange value of currencies relative to one another and was hampering trade and economic growth. Starting in the early 1970s, the Bretton Woods system was replaced by a foreign exchange market in which currencies “float.” That is, the relative value of currencies to one another is determined by supply and demand.

Monetary Policy

Sometimes a government believes it can promote domestic economic growth and employment or control inflation by fixing the value of its currency relative to another currency such as the U.S. dollar. Typically, the country’s central bank sets monetary policy and employs strategies to intervene when supply and demand in the foreign exchange market threaten to alter the currency’s value. The goal is to stabilize the exchange rate at a level that serves to further the government’s economic goals.

Implementation

In essence, when monetary policy is used to fix an exchange rate, currency is bought and sold to offset the influence of supply and demand in the foreign exchange market. For example, starting in 1977, Mexico’s central bank fixed the exchange rate for the peso at 23 pesos per U.S. dollar. When demand for pesos was high, the central bank sold pesos to keep the price from going up. When demand was low, the central bank used its reserves of U.S. dollars to buy pesos and so create a price support.

Problems

One important feature of the system of floating currencies is that small adjustments due to supply and demand forces lead to comparable prices for goods in different countries. These adjustments don’t take place when a country uses monetary policy to fix the exchange rate, so over time discrepancies build up. In the case of the Mexican peso, inflation in Mexico outpaced inflation in the United States. By the early 1980s, the domestic prices of Mexican goods were markedly different than the prices for the same goods in the United States. In 1982 the Mexican central bank nearly exhausted its reserves trying to keep the exchange rate at 26.6 pesos per dollar and had to abandon its rate-fixing policy. The exchange value promptly fell so that it took 45 pesos to buy one dollar. The dislocation and built-up market pressures led to a complete collapse of the peso. By the end of the 1980s it took 3,000 pesos to buy a U.S. dollar.

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