With a fixed exchange rate and perfect capital mobility the domestic interest rate must
match foreign interest rates to prevent massive capital flows and allow equilibrium in the
forex market. Monetary sovereignty is then lost. Monetary policy cannot be used
independently to control the domestic economy.
A fall in domestic demand causes a fall in output and a decline in prices. Unlike a closed
economy, monetary policy cannot respond by cutting interest rates. Rather, the fall in prices
boosts competitiveness and raises aggregate demand. When internal balance is restored,
there is now a current account surplus. This generates greater wealth, raising domestic
demand again. After a temporary boom to raise prices and reduce excess competitiveness,
internal and external balance can be restored.
A fall in export demand generates a slump, lower prices and higher competitiveness that
restores internal and external balance. No subsequent boom is then required.
In the short run, fiscal policy is a powerful tool under fixed exchange rates. Fiscal expansion
no longer bids up domestic interest rates in the short run. Output expansion is
accompanied by a rise in the money supply to maintain interest rates at the world level.
A devaluation is a fall in the value of the fixed exchange rate. With sluggish price adjustment,
it raises competitiveness and aggregate demand. With spare resources, output rises. But at
potential output, net exports can rise only if domestic absorption is cut by tighter fiscal
policy.
In the long run, devaluation is unlikely to have much effect. Changing one nominal variable
merely leads to offsetting changes in other nominal variables. In passing on higher import
prices and seeking cost-of-living wage increases, firms and workers offset the competitive
advantage of devaluation. But devaluation may speed up adjustment to a shock that
requires a permanent change in competitiveness to restore internal and external balance.
Under floating exchange rates, the long-run level of the nominal exchange rate achieves
external balance, given prices at home and abroad. In the short run, the exchange rate
adjusts to prevent massive flows on the capital account.
The exchange rate must begin at a level from which the anticipated convergent path to its
long-run equilibrium continuously provides capital gains or losses to offset expected interest
rate differentials, thus equating the expected return on lending at home and abroad.
Under floating exchange rates, monetary policy is a powerful short-term tool. The belief that
interest rates will be higher for some time induces a sharp appreciation of the exchange
rate, so that it can then credibly promise capital losses to offset high interest rates. With
sluggish price adjustment, the initial appreciation of the nominal exchange rate causes a
sharp fall in competitiveness. This reduction in demand for net exports reinforces other
effects of high interest rates in reducing aggregate demand.
Fiscal policy is a weaker tool under floating exchange rates. Fiscal expansion induces a
boom and higher interest rates. The latter induce an exchange rate appreciation that
crowds out some net exports, reinforcing domestic crowding out of consumption and
investment.
The actual path of the UK nominal exchange rate reflects changing beliefs about the future
course of domestic and foreign interest rates, and about the eventual level of the exchange
rate in long-run equilibrium. The latter depends on beliefs about the eventual price level at
home and abroad, and also on supply shocks such as resource discoveries.
