Under the fixed exchange rate
system, the condition under which fiscal policy can be effective in affecting the level of GDP is also agreed upon by all economists.
(2) In the fixed exchange rate
system that the Bretton Woods charter ratified' there was a clear-cut division of labour.
So the model is consistent with the idea that the fixed exchange rate
regimes in Korea and Thailand collapsed after agents understood that the banks were failing, but before governments actually started to monetize their deficits.
McNamara then constructs her alternative theory, which she builds upon Mundell's "Holy Trinity": "Policymakers can choose only two out of three policy options at any one time: free capital flows, a fixed exchange rate
, and monetary policy autonomy" (p.
The reason for maintaining a fixed exchange rate
, or one that trades within an exchange-rate band, is to keep a lid on inflation.
"You can cash in euro cheques anywhere - it's legal tender with a fixed exchange rate
so people have nothing to fear."
On the other hand, adherence to a fixed exchange rate
implies a loss of domestic monetary policy autonomy.(1) Without the ability to use monetary policy to counter localized economic shocks, countries may suffer unnecessary welfare losses in output or employment.
The answer depends on a number of factors, including the degree of integration, the relative size of the country, and the choice of flexible versus fixed exchange rate
The combination of continued strong demand for dollars to meet debt service obligations and the slowed new supply destabilized the previously fixed exchange rate
Authorities therefore could face down a challenge from the masses, when defense of the convertibility of domestic currencies (into the weight of gold specified by the fixed exchange rate
) required raising interest rates and contracting economic activity.
Another frequently used nominal anchor entails fixing the value of the domestic currency relative to that of a low-inflation country, say Germany or the United States, or, alternatively, putting the value of the domestic currency on a predetermined path vis-a-vis the foreign currency in a variant of this fixed exchange rate
regime known as a crawling peg.
Also, there is a danger of fixed exchange rate
quickly becoming overvalued if a currency board is introduced in an attempt to stop high inflation.