Monetary policies are very important when governments are out to stabilize the economies.

This is attributed to the fact that, it is much easier to enact monetary policy decision than a fiscal policy decisions. Having monetary policies is a clear avenue for flexible exchange rates (Betts & Michael, 2000). The ranging inflation makes the domestic level rise, this in the results to appreciation and very high account deficits; fixed exchange rate is actually beneficial by rendering the central bank component. For the fixed exchange rate, it does not move around in the short run. Exporters and importers don’t have to be afraid by the hedging open currency positions or even the demand of goods fluctuating along the relative price (Chari, Patrick & Ellen, 2002).

When monetary policy is implemented through fixed exchange rate system, the main aim is to maintain low inflation and maintaining an adequate level of foreign reserves (Clarida, Jordi & Mark Gertler, 2000). Moreover, when this one is used, the central bank acquires control over the monetary base, since it does not have to do any additional or even subtraction liquidity derived from compulsory interventions in the foreign exchange market. But having a fixed exchange system, the central bank influences interests rates and exchange rtes through the general price level (Devereux, Michael & Charles, 2003).

Due to the transparency in the system, this process is effective in stabilizing the inflation expectations, the exchange rate and the evolution of inflation. Conclusively, under the fixed exchange rate system, a country’s current account deficit can become substantially larger than its account surplus and therefore it is very hard for then to face a balance of payment crisis. Moreover, the rates also act as an automatic stabilizer to external shocks. In other words, they facilitate relatively painless adjustment to negative events in other countries that affect the host country (Devereux, Michael & Charles, 2003)

References

Betts, Caroline and Michael B. Devereux (2000): “Exchange Rate Dynamics in a Model ofPricing-to-Market”, Journal of International Economics 50,1,215-244

Chari, V.V., Patrick Kehoe, and Ellen McGrattan (2002): “Monetary Shocks and Real ExchangeRates in Sticky Price Models of International Business Cycles,” Review of EconomicStudies 69, 533-563

Clarida, Richard, Jordi Galí, and Mark Gertler (2000): “Monetary Policy Rules andMacroeconomic Stability: Evidence and Some Theory,” Quarterly Journal ofEconomics, vol. 105, issue 1, 147-180.

Devereux, Michael B. and Charles Engel (2003): “Monetary Policy in the Open EconomyRevisited: Exchange Rate Flexibility and Price Setting Behavior”, forthcomingReview of Economic Studies.