Figure 16.2 Reaction to Monetary Policy This flowchart shows the reaction of the economy to an increase in money supply under both flexible and fixed exchange rate systems.
16.6 Monetary Policy Under Fixed Exchange Rates
When the exchange rate is fixed, the balance of payments deficit created by a stimulating dose of monetary policy does not cause the exchange rate to fall. Instead, it causes a decrease in the money supply as the Fed buys dollars with foreign exchange to prevent the balance of payments deficit from lowering the exchange rate. The decrease in the money supply diminishes the stimulating effect of the policy dose, making monetary policy weaker in affecting the income level. This sequence of events is also shown in figure 16.2.
There is more to this story however. An increase in the money supply created the balance of payments deficit, and an automatic decrease in the money supply is decreasing the deficit. Consequently, only when the original money supply increase has been completely wiped out will the deficit be eliminated. The economy will regain equilibrium back where it started, so the end result of this monetary policy is no change. This reflects an extremely important general result: under a fixed exchange rate, monetary policy is completely ineffective as a policy tool. Monetary policy implicitly is being used to fix the exchange rate, so is not available for other purposes.
