Chapter 20
Fixed exchange rates in the Monetary Model

An important application of the Monetary Model was to gain insights into fixed exchange rate regimes. In a fixed exchange rate regime, the central bank of a country wants to maintain the exchange rate at a certain, predetermined level $\overline{S}$.¹ Suitable measures for this purpose include a forward-looking monetary policy that selects interest rates appropriately, foreign exchange market interventions and, as ultima ratio, restrictions on capital movements. This means, however, that monetary policy no longer autonomously follows its own goal, such as price level stability, but is coupled to the monetary policy of the anchor country through the exchange rate. We have already seen above that monetary policy measures change the exchange rate. Therefore, if the central bank wants to keep the exchange rate stable at $\overline{S}$ , it must use monetary policy measures to compensate for shocks affecting the exchange rate (e.g. inflation abroad, economic growth, but also the monetary policy of the foreign country).

In order to illustrate the foreign exchange market interventions in the model, we look more closely at the composition of the money supply. The domestic money stock $M$ is made up of two components: the domestic credit stock $\mathit{DC}$ and the foreign exchange reserves $\mathit{FX}$

$$M=\mathit{DC}+\mathit{FX}$$

The distinction between DC and FX is based on the "source" or origin of the money in circulation. If foreign exchange or gold is bought in the foreign exchange market (FX rises), it is paid for with freshly created money, i.e. the money supply increases. If, on the other hand, the central bank sells reserves (FX falls), these must be paid for with domestic money. This money is thus withdrawn from the economy, since it goes back to the central bank, and the money supply $M$ sinkt. in circulation decreases. The domestic credit $\mathit{DC},$ – the money supply that flows into the economy via the banks – is a policy variable in our analysis. In other words, $\mathit{DC}$ is determined by politics within the framework of economic policies. The foreign exchange reserves $\mathit{FX}$ are used for the adjustment of the monetary policy to achieve exchange rate stability. The foreign currency and gold reserves are thus ultimately the residual value that adjusts to keep the exchange rate stable. As we will show, the following is the case: $\mathit{FX}$ rises (falls) when there is increased (decreased) demand for domestic currency.

The graphical presentation is shown in a third graph, which illustrates the composition of the money supply. The graph was integrated by an initial scale adjustment with $M=P$. Here, the point $\mathit{DC}$ is movable but it can only be changed to such an extent that the reserves do not become negative. In the following graphs we will examine this relationship in more detail.