Unit 7 Macroeconomic policy in the global economy

7.2 Exchange rate regimes, monetary policy, and inflation

Unit 5 explains how macroeconomic stabilization policy works in a model of an economy where an independent central bank sets the policy interest rate in response to shocks with the objective of keeping inflation reasonably close to target. In this model, the ultimate determinant of inflation is the central bank’s target inflation rate. The central bank adjusts the interest rate to alter aggregate demand, so as to keep unemployment close to equilibrium, where inflation is constant. To the extent that it is perceived as successful in pursuing the inflation target, this can help to anchor inflation expectations, and thereby reduce the output and employment costs of getting inflation under control.

exchange rate

The number of units of home currency that can be exchanged for one unit of foreign currency. For example, Australia’s exchange rate between the Australian dollar (AUD) and the US dollar (USD) is defined as the number of AUD per USD. An increase in this number is a depreciation of the AUD, and a decrease is an appreciation of the AUD.

policy (interest) rate

The nominal interest rate set by the central bank, which applies to banks that borrow base money from each other, and from the central bank. Also known as: base rate, official rate. See also: real interest rate, nominal interest rate.

nominal exchange rate

The number of units of the home currency that have to be exchanged to obtain one unit of a foreign currency—that is, the market exchange rate—is described as a nominal exchange rate to distinguish it from the real exchange rate, which is the relative price of foreign and domestic goods and services. See also: real exchange rate.

real exchange rate, competitiveness

The relative price of foreign and domestic goods and services; specifically, it is the price of foreign goods and services, converted into domestic currency at the market (nominal) exchange rate, divided by the price of domestic goods and services. The real exchange rate is a measure of competitiveness.

In Unit 5, we described how the central bank conducts monetary policy without saying very much about the exchange rate. But we did show, as summarized in Figure 5.20, that in such economies, changes in the exchange rate play an important role in reinforcing the impact of changes in monetary policy. For example, when the central bank tightens monetary policy by raising the policy interest rate, it will expect this to lead to an appreciation of both the nominal and real exchange rate, resulting in both reduced aggregate demand and lower inflation.

This model of monetary policy, reinforced by movements in the exchange rate, matches the data well for a number of countries, particularly in more recent years, when governments in many countries have made their central banks independent, with a mandate to pursue a clear and stable inflation target.

But the model does not match the inflationary experience of Argentina or Türkiye, for example, or Spain and the UK during the 1970s and 1980s. And in this unit, we will also discuss other countries that have managed to stabilize their inflation rate by deliberately giving up. In such countries the nominal exchange rate is either fixed, or very tightly controlled.

So in this unit we explore a wider range of monetary policy and exchange rate regimes that allow us to better understand the experiences of different countries around the world, at different times. We consider the implications of these different regimes for inflation, exchange rates, interest rates, and the wider macroeconomy, with a particular focus on the role of globally integrated financial markets.

Flexible versus fixed exchange rate regimes

Policy options depend critically on whether the exchange rate is flexible or fixed.

flexible exchange rate

A country’s exchange rate is flexible if it can change in response to trading in the foreign exchange markets, rather than being held constant by the government or central bank. See also: exchange rate, fixed exchange rate.

In our model of monetary policy in Unit 5, we assumed a flexible exchange rate regime. In such a regime, we assume that exchange rates are entirely determined by the interactions of buyers and sellers in the ‘forex’ (foreign exchange) market. Just as in other financial markets, this can lead to significant volatility in nominal exchange rates. If the demand for yen rises relative to the demand for dollars, then the yen appreciates and vice versa.

Using the policy interest rate to target inflation means it cannot be used to target a specific exchange rate. The country controls its monetary policy, but not its exchange rate.

fixed exchange rate

A country’s exchange rate is fixed if it is managed by the central bank or the government, and either held constant over time or kept within a narrow range of values. A country in a common currency zone effectively has a permanently fixed exchange rate relative to all other countries in the zone. See also: exchange rate, flexible exchange rate.

Different countries have different mechanisms for fixing the exchange rate. But this unit will show that what all fixed exchange rate regimes have in common is that fixing, or targeting a given value of the exchange rate means that the interest rate cannot be used to manage aggregate demand in the economy. The reason is that changing the interest rate to raise or lower aggregate demand will usually cause a change in the exchange rate, moving it away from the targeted rate. So countries with a fixed exchange rate do not have the option of using monetary policy to stabilize their economy when there is a demand or supply shock.

There is a variety of methods for fixing the exchange rate. What is clear is that the interest rate cannot be used to manage aggregate demand in the economy if the policymaker wants to keep the exchange rate unchanged or close to a target rate. The reason is that changing the interest rate to raise or lower aggregate demand will cause a change in the exchange rate, moving it away from the targeted rate. So countries with a fixed exchange rate do not have the option of using monetary policy to stabilize their economy when there is a demand or supply shock.

Figure 7.4 illustrates the contrasting behaviour of the nominal exchange rate in two countries: Japan, with a flexible exchange rate regime and Denmark, with a fixed one.

Figure 7.4 shows that the exchange rate of the Japanese currency (yen) against the dollar has varied by large amounts both in the short term (the chart shows daily observations) and even more so over the longer term. Between 2012 and 2024, for example, the price of a dollar in yen almost doubled: that is, the yen depreciated by a large amount against the US dollar.

The exchange rate of the Danish currency (kroner) against the euro provides a marked contrast. It is not completely fixed: from day to day it does vary, but only by very small amounts; and over the period shown in the chart it has reliably stayed within a very narrow range of the Danish central bank’s target value of 7.46 kroner to one euro. So for all practical purposes, we can view this as an effectively fixed exchange rate.

In this unit, we compare the outcome of fixed versus floating exchange rates. We will show that fixing the exchange rate can help countries stabilize domestic inflation, especially if they have been unsuccessful in doing so in the past, but there are also macroeconomic costs of doing so.

Three alternative monetary regimes

Since not all economies are characterized by the conditions assumed in Unit 5, we will examine how stabilization policy works in different economies, depending on the role of the central bank, and how the exchange rate is determined. We consider two questions:

• Does a country set its own national monetary policy or, instead, delegate it to another country (or entity like the European Central Bank)?
• If a country does set its own monetary policy, does it grant operational independence to the central bank to pursue a stable inflation target?

We classify the country’s monetary policy and associated exchange rate regime as one of three types:

1. FlexIT: A Flexible exchange rate with an Inflation Target
2. FlexNIT: A Flexible exchange rate with No stable Inflation Target
3. Fix: A Fixed exchange rate

As with all models, these are not precise descriptions of particular economies. Not all countries fit exactly into one of these categories; but by focusing on three cases, we can understand many features of actual economies all over the world.

FlexIT: A flexible exchange rate regime with a stable and credible inflation target

This is the Unit 5 model. It is based on the assumption of a flexible exchange rate (determined in the foreign exchange markets) combined with a central bank that is given operational independence to set monetary policy in pursuit of an inflation target. The inflation target is ‘stable’ when the central bank keeps actual inflation close to the target, which in turn results in the target being credible. In this framework, we showed in Unit 5 that movements in the exchange rate make monetary policy more powerful, reinforcing the effect of interest rate changes on inflation in two ways:

• Via aggregate demand. When the central bank tightens policy (by raising the policy interest rate), it will anticipate that this will result in both nominal and real exchange rate appreciation, which will dampen net exports and hence output, thereby reinforcing the impact of interest rate changes through the aggregate demand channel. Conversely, a relaxation of monetary policy will normally cause an exchange rate depreciation, which will stimulate the real economy.
• By directly affecting inflation. Changes in the exchange rate also have a powerful direct effect on CPI inflation, via import prices. Tighter policy and exchange rate appreciation dampen inflation and vice versa.

We use this model as a benchmark for comparison, to highlight the characteristics of the two new cases introduced in this unit.

For the three countries whose inflationary experience is shown in Figure 7.3, the FlexIT model fits Germany’s experience quite well. In the early part of the period, monetary policy was controlled by its central bank, the Bundesbank, which had both operational independence and a strong commitment to low and stable inflation.

common currency area, currency union, monetary union

A common currency area (sometimes called a currency union or monetary union) is group of countries that use the same currency. This means there is just one monetary policy for the group.

In 1999, the eurozone was formed: Germany and ten other European countries adopted a common currency, the euro. From 1999 onwards, control over their monetary policy was handed over to the European Central Bank (ECB), which has a clear mandate to stabilize inflation at close to 2%. The only difference is that the ECB sets policy on a eurozone-wide basis, but for Germany at least (as the dominant economy in the eurozone) this still resulted in very stable inflation.

The FlexIT model also matches up well with the UK experience since 1997, when the government ‘tied its own hands’ by giving up control of monetary policy to the central bank. The Bank of England was given operational independence and a mandate to pursue an inflation target. Since 1997, UK inflation has been quite stable around the target value.

For Spain, inflation was also low on average after it joined the eurozone in 1999. But Figure 7.3 shows that the FlexIT model does not describe the experience of either Spain or the UK in the 1970s and 1980s. This experience, and that of other high-inflation countries (including some, like Argentina, with very high inflation) is better described by the next model.

FlexNIT: A flexible exchange rate regime with no stable and credible inflation target

The second model applies to countries that have a flexible exchange rate, but have not delegated authority for monetary policy to an independent central bank with a stable and credible inflation target.

In such countries, we will show that high and volatile inflation leads to frequent exchange rate depreciations. And rather than helping to stabilize inflation by reinforcing the interest rate channel of monetary policy, movements in the exchange rate often reinforce inflationary shocks, making the situation worse.

This category captures the inflationary experience of a wide range of countries, from Spain and the UK in the 1970s and 1980s to Argentina, where inflation has often been much higher, for much longer.

For both Spain and the UK, the experience of high and volatile inflation proved relatively short-lived. The UK transitioned from a FlexNIT to a FlexIT economy. But Spain took a different route to bringing inflation down. In 1999, it abandoned the Spanish currency, the peseta, entirely and joined the eurozone—a special case of our next model.

Fix: A fixed exchange rate

Data in Figure 7.15 (Section 7.6) shows that roughly half of the world’s population lives in countries with a fixed (or target) exchange rate regime, in which the nominal exchange rate is either completely fixed or moves by relatively small amounts. In all such countries, even when the exchange rate is not completely fixed, it is much more stable than in countries like Japan, which has a fully flexible exchange rate that, as Figure 7.4 shows, has been very volatile.

To simplify the analysis, we model the case where the nominal exchange rate does not change at all. We will show that, for as long as the home country maintains a fixed exchange rate, it cannot use the interest rate—the tool of monetary policy in a FlexIT regime—to target inflation. This means that countries with fixed exchange rates do not control their own monetary policy: they depend on the monetary policy of another country (the ‘foreign’ economy).

As explained further in Section 7.4, a common currency area like the eurozone can be modelled as an extreme case of a fixed exchange rate. Members of the eurozone give up national control of monetary policy to the European Central Bank.

FlexIT benchmark regime: The impact of a country-specific demand shock

To compare the operation of monetary policy in the three regimes, we analyse the effects of a country-specific aggregate demand shock in each one. As a benchmark, we begin with the FlexIT regime, familiar from Unit 5. In all these cases, we make the simplifying assumption that nothing changes in the foreign economy, so this is a purely domestic shock.

Consider a FlexIT economy like that of the UK, where (since 1997) the Bank of England sets monetary policy to meet the government’s inflation target. What happens if the UK experiences a demand shock—for example, a boom in housing investment?

Figure 7.5 works through the process.

Figure 7.5 illustrates how the central bank will stabilize the economy following the demand shock, restoring inflation to the target level. The bank raises the interest rate and this leads to an exchange rate appreciation, depressing net exports, which reinforces the effect of the interest rate in offsetting the rise in aggregate demand. There is also an additional effect on inflation because exchange rate appreciation decreases import prices, and imports typically make up a substantial share of consumption. Figure 7.6 summarizes the impacts of depreciation and appreciation in this model.