Influence of Exchange Rate Regime on Effectiveness of Monetary Policy - Example

Influence of Exchange Rate Regime on Effectiveness of Monetary Policy The exchange rate regime used by a country greatly influences the effectivenessof the monetary policies of that nation. In this paper, I rely mainly on the IS-LM BP model to explain the influence of exchange regime in use on the effectiveness of its monetary policy. This model is among the most popular standard macro models that explains different characteristics of an open economy. An open economy is an economy in which a country trades with other countries in goods, services, and financial assets (Redseth 2000). Most of the economies in the current world are open due to globalization of trade. According to Cespedes, Chang & Velasco (2002, p. 1), “this kind of a model treats the financial markets and international capital mobility as perfect.” Therefore, by using this model to explain the effectiveness of a monetary policy, we would be making an assumption that capital mobility and financial markets are perfect. A country can apply either a fixed exchange rate regime or a flexible exchange rate regime in its monetary system. These two regimes differ both in their characteristics and in applicability. Unlike a flexible regime, a fixed regime has an automatic monetary policy response that the monetary institution has little influence on (Klein & Shambaugh 2010). However, they both define how the currency of a country exchanges with currencies of other countries. According to IMF (1988), exchange rates influence capital flow in and out of the country. Therefore, since the exchange rate regime adapted would influence the exchange rates then it would influence the capital flow in and out of the country. A monetary policy affects the money market of a country. This type of policy is crucial in finding a solution to economic problems. Its basis is the supply of money rather than the terms and rates of trade (Jain & Khanna 2007). Therefore, the monetary institutions design this kind of a policy to control either the amount of currency in circulation or the cost of a currency relative to currencies of other nations. However, in controlling the amount of currency in circulation and cost of a currency, the policy should control the terms and rate of a trade in a country. That is now where the issue of the effectiveness of a policy comes from. An effective monetary policy is one that has the capacity to control terms and rates of trade thus controlling the economy of the country. The three lines in the IS-LM BP model are the open IS curve, the open LM curve and the BP curve (Chamberlin & Yueh 2006). Although we use the word ‘curve’ to mention them, in a diagram they are represented as straight lines. We can use this kind of a model for different purposes one of them being the analysis of a policy. When we use this model to analyze a policy, each of these curves would represent a different aspect of the policy that can identify its effectiveness. In this case, what we would be interested in is the intersection point of the lines in the model. Below is an illustration of this type of a model retrieved from the internet. Diagram of the IS-LM BP model (Deardorff 2010, p. 1) Each line in the diagram above is a representation of an aspect of a monetary policy that we aim to analyze. We can observe from the diagram that all the three curves intersect at one point called the equilibrium point. We can use these lines to explain how a monetary policy affects the economic activities of a country and thus draw a conclusion of its effectiveness. According to Furstenberg (1984), international exchange of national money and monetary equilibrium are the main causes of the effectiveness of monetary policy. We could use the IS-LM BP model to represent and interpret these aspects of the monetary policy. The intersection of all the curves in the model represent the monetary equilibrium while each of the curves represent an aspect of international exchange of national money. The nature of the curves, its shifts, and their point of intersection depend on the exchange rate regime in use in that specific country. When a fixed exchange rate regime is in use, the nature of the model is different from when a flexible exchange rate regime is in use. The exchange rate regime influences the effectiveness of a monetary policy in four different ways. The ways are capital flow, monetary expansion, fiscal expansion, and devaluation (Deargorff 2010). The IS-LM BP model diagram can diagrammatically show these four ways and how they relate to the effectiveness of monetary policy. The shift in the curves of the models in the diagram is different when either regime is used. This clearly indicate how different regimes makes this ways to react differently thus showing how the effectiveness of a monetary policy changes according to the regime in use. The capital flow experienced in a country depends solely on the foreign exchange regime in use. Capital flow is the movement of financial assets across nations (Kawal & Lambert 2011). The monetary policy of a country should be able to control the flow of money in a country for us to regard it as effective. For a fixed regime, increase in capital flow shifts only the BP curve of IS-LM BP model. This shows that capital flow affects only the balance of payment in a fixed regime. Therefore, the monetary policy designed for controlling capital flow cannot be an effective policy. For a flexible exchange rate regime, an increase in capital flow shifts all the curves in the model. This shows that a change in capital flow result to an equal change in the exchange rate and other aspects of the economy. Therefore, in this kind of a regime, monetary policy designed to control capital flow will actually turn up to be an effective policy. Another factor that we can consider to understand the effect of a chose regime to the effectiveness of a monetary policy is monetary expansion. According to Deardorff (2010), monetary expansion is the increase in the supply of money in an economy. When, we undertake monetary expansion in an economy, the LM curve of the model shifts to the right regardless of whether the regime in use is either flexible or fixed. However, for a fixed regime, the shift does not result to a shift in the other curves and thus we would have disequilibrium. This disequilibrium will be an indication of a deficit in the balance of payment. Since in this kind of a regime monetary policy cannot be able to remove this deficit then it is ineffective. For a flexible regime, the supply of money in an economy result to decline in the value of the money and thus the effect is cushioned. Therefore, in this kind of a regime, monetary policy is more effective in controlling the economy of the country. Another way we can use to determine the effectiveness of monetary policy in either regime is the fiscal expansion. By undertaking fiscal expansion, we would stimulate economic activities and thus revive economic conditions (Morsy & Kandil 2010). However, the stimulus of such an activity depends on regime used by the country. For a flexible regime, this kind of an expansion results in an equal shift in all the three curves of our model. Therefore, the model would not indicate any form of deficit in the economy since the fall in the currency value would cushion any deficit. Hence, the monetary policy would be effective. For a fixed regime, this expansion shifts only the IS curve of our model, which results to disequilibrium. This disequilibrium makes an economy to experience a deficit and thus monetary policy is not effective in this kind of a regime. We can also use currency devaluation to determine the effectiveness of monetary policy. The devaluation of a national currency is actually lowering its value relative to other currencies. The value of a country’s currency connects directly to the economy of that country (Hollander 2011). Therefore, any effort to devaluate the currency through the monetary policy is to revive the economy. For a fixed exchange regime shifts the IS curve to the right and the BP curve down thus creating a BP surplus (Deardorff 2010). Therefore, it does not assist in economic recovery and hence any monetary policy aimed to devaluate a currency would be ineffective in this kind of a regime. However for a flexible regime devaluation of a currency result to a shift in the equilibrium point and thus could act as a solution to an economic problem. Therefore, monetary policies are more effective when a flexible exchange rate regime is in use. An example of a shift in the curves of the IS-LM BP model in both the flexible and fixed regimes is as illustrated below. An example of the IS-LM BP model diagram for a fixed exchange rate regime (UH n.d, p. 8) An example of the IS-LM BP model diagram for a flexible exchange rate regime (UH n.d, p. 9) References Cespedes, LF, Chang, R & Velasco, A 2003, ‘IS-LM-BP in the Pampas, Viewed 2 August 2012, . Chamberlin, G & Yueh, L 2006, Macroeconomics, London, Thomson Learning. Deardorff, AV 2010, Deardorffs’ Glossary of International Economics, viewed 2 August 2012 < http://www-personal.umich.edu/~alandear/glossary/figs/islmbp/islmbp.html#>. Furstenberg, GMV 1984, International Money and Credit: The policy Roles (EPub), Washington: International Monetary Fund. Hollander, BG 2011, Real World Economics: How Currency Devaluation Works, New York: The Rosen Publishing Group. IMF, 1988 Policy Coordination in the European Monetary System-Occa Paper 61 (EPub), London: International Monetary Fund. Jain, TR & Khanna, OP 2007, Economic Concepts and Methods, New Delhi: V.K Enterprises. Kawal, M & Lambert, MB 2011, Managing Capital Flow: The Search for a Framework, Cheltenham: Edward Elgar Publishing Limited. Klein, MW & Shambaugh, JC 2010, Exchange Rate Regimes in the Modern Era, Cambridge: MIT Press. Morsy, H & Kandil, ME 2010, Fiscal Stimulus and Credibility in Emerging Countries, Washington, International Monetary Fund. Redseth, A 2000, Open Economy Macroeconomics, New York: Cambridge University Press. UH n.d, Open Economy Macroeconomics: The IS-LM BP Model, viewed 2 August 2012 < http://www.uh.edu/~egentile/4389-IS-LM-BP.pdf>. Read More