11 Monetary policy under floating vs. fixed ER
11.1 Two channels of expansionary monetary policy
When the Fed eases (\uparrow M^S):
- Interest-rate channel. \downarrow r \Rightarrow \uparrow I^d \Rightarrow \uparrow Y.
- Exchange-rate channel. \downarrow r \Rightarrow capital outflow \Rightarrow home currency depreciates \Rightarrow \uparrow (X-M) \Rightarrow \uparrow Y.
11.2 Under flexible ER: both channels reinforce
Both channels push Y up. Monetary policy is potent under floating exchange rates — that’s one reason the U.S., UK, Japan, eurozone all run floating regimes.
11.3 Under fixed ER: only channel 1 operates
The central bank is committed to keep the ER stable. When monetary easing causes capital outflows that would depreciate the currency, the central bank must intervene — selling its FX reserves and buying back its own currency. That contracts M^S back toward where it started.
Net effect: monetary easing under a fixed ER is muted. Channel 1 (interest-rate) operates partially; channel 2 (FX) is dead.
11.4 The trilemma
A country can choose at most two of these three:
- Free capital flow.
- Fixed exchange rate.
- Independent monetary policy.
| who picks what | example |
|---|---|
| Free capital + floating ER, give up fixed ER | U.S., UK, Japan, Eurozone |
| Free capital + fixed ER, give up independent monetary policy | Hong Kong (USD peg), members of a currency union |
| Fixed ER + independent policy, give up free capital | China historically (capital controls) |
This is why monetary unions are a big deal. Joining the Eurozone is choosing column 2 — you fix your ER (effectively, by adopting the same currency) and accept that the ECB sets monetary policy for everyone.