In a regime of , how could a central bank manage its monetary policy and its foreign exchange market intervention policy ? Why do you need foreign exchange reserves? The last 20 years have seen increased international interdependence due to reduced controls on capital flows between countries. Furthermore, since the early 1970s, many countries have allowed greater flexibility in their exchange rates. These developments have raised several questions: How does the exchange rate regime affect the effectiveness of national monetary and fiscal policies undertaken by small and open economies? In response to this question, many analysts, such as exchange rate and balance of payments analysts, using the IS-LM model, have contributed to the rapid development of open economy models. An exchange rate regime is a description of the conditions under which the national government allows the determination of the exchange rate. There are three types of exchange rates: fixed, flexible and managed exchange rate. In a fixed exchange rate regime, national governments agree to maintain the convertibility of their currency at a fixed exchange rate. Say no to plagiarism. Get a tailor-made essay on "Why Violent Video Games Shouldn't Be Banned"? Get Original Essay A currency is convertible if the government, acting through the central bank, agrees to buy or sell most of the currency that people want to exchange at the fixed exchange rate. Most central banks act as the government's banker, bank of banks, lender of last resort, and issuer of banknotes, as well as overseeing the banking system and implementing monetary policy. Monetary policy refers to attempts to manipulate the interest rate and money supply so as to bring about desired changes in the economy. The objectives of monetary policy are the same as those of economic policy in general. They are the maintenance of full employment, price stability, a satisfactory rate of economic growth and balance of payments equilibrium. In a fixed exchange rate regime, governments are committed to intervening in the foreign exchange market to maintain a certain nominal exchange rate. It is important for the central bank to intervene to buy or sell foreign currency in the open market economy. It is very worrying that foreigners buy assets in any country they choose, quickly, with low transaction costs and on unlimited accounts due to perfect capital mobility. Perfect capital mobility means that the government cannot set independent targets for both the money supply and the exchange rate. This also implies that any one country's interest rates cannot go too far out of line without triggering capital flows that tend to push yields back to the world level. With fixed exchange rates, the government must accept the domestic money supply which makes domestic and foreign interest rates equal. It is understandable from the above statement and also looking at the Mundell-Fleming theorem, that there will be extreme capital flows even if there will be even a slight change in interest rates. Therefore, with perfect capital mobility, central banks cannot conduct an independent monetary policy with a fixed exchange rate. For example, if a country increases its interest rate by tightening its monetary policy. Immediately, investors shift their wealth to take advantage of the new rate and thus the result would be a massive inflow of capital. The balance of payments will now show a gigantic surplus;foreigners try to buy domestic assets, tending to make the exchange rate appreciate and forcing the central bank to intervene to keep the exchange rate constant. Buy foreign currency in exchange for national currency. This intervention occurs until interest rates return in line with those of the world market. When price adjustment is slow, there is an increase in nominal money supply that increases the real money supply in the short run and tends to reduce national interest rates. With perfect capital mobility, this leads to an outflow of capital accounts until the domestic money supply is reduced to its original level and interest rates return to world levels. So domestic politics is impotent in a fixed exchange rate regime when capital mobility is perfect. Looking at this point in terms of the open economy IS-LM model. Figure 1 shows that in perfect capital mobility the balance of payments can only be in equilibrium at the interest rate. Even at slightly higher or lower interest rates, capital flows are so massive that the balance of payments cannot be in equilibrium and the central bank must intervene to maintain the exchange rate. The intervention shifts the LM curve. Due to the decrease in the interest rate due to monetary expansion, the economy moves from E to E'. But in E' there is strong pressure from the payments deficit on the exchange rate. Therefore, the central bank must intervene, selling foreign currency and receiving domestic currency. Therefore, the LM curve returns to the initial point E. In fact, with perfect capital mobility the economy never reaches point E'. The capital flow response is so large and rapid that the central bank is forced to reverse the initial expansion of the money supply as soon as it attempts to do so. This therefore demonstrates that monetary policy under a fixed exchange rate regime is totally ineffective. However, fiscal policy is very effective in a fixed exchange rate regime. With the money supply unchanged, the IS curve shifts up and to the right, tending to increase both the interest rate and the level of output. The higher the interest rate triggers an inflow of capital which would lead to an appreciation of the exchange rate. To maintain the exchange rate, the central bank must expand its money supply by further increasing income. As in Figure 2, equilibrium is restored when the money supply has increased enough to bring the interest rate back to its initial position. Monetary policy is effective when it is in a flexible exchange rate regime. From Figure 3 we can see the actual intervention of the central bank in the foreign money market. Here the dollar-sterling exchange rate is fixed at e1. The fixed exchange rate, e1, would be the equilibrium rate if the supply curve was SS and the demand curve DD. With neither excess supply nor excess demand for pounds, no one would want to buy or sell pounds to the central bank. The market would clear up on its own. When the demand for sterling is in DD1, there is excess AC demand. The Bank of England steps in by offering AC pounds in exchange for dollars, which are added to the UK's foreign exchange reserve. Foreign exchange reserves represent the stock of foreign currency held by the national central bank. When demand is DD2, foreigners would buy fewer British goods, which will decrease demand for the pound. The bank sells off part of its foreign exchange reserves in exchange for pounds. It requires EA pounds to offset the EA oversupply at the e1 exchange rate. When demand is DD, the market stabilizes at the exchange rate e1 and no intervention takes place.