20.2 Recession with fixed exchange rates

Which implications has a fixed exchange rate for economic politics? In most cases, exchange rates are fixed in order to intensify trade relations, to bind oneself to the monetary stability of the anchor country, or generally to stabilize the economy with the help of this external anchor. Within the Monetary Model, however, we can show that this also leads to an amplification of endogenous growth shocks, i.e. if there is weak growth or recession, exchange rate-oriented monetary policy reinforces this and makes the crisis worse. In such a case, the government can either try to counteract a worsening of the economic crisis, abandon the exchange rate target or adjust the target with devaluation. On the other hand, this monetary policy also reinforces positive growth impulses. The following chart illustrates these relationships.

With the slider an exogenous growth shock can be shown. In the case of a recessive shock this means that income $Y_0$ is reduced to $Y_1$ As a result, the price level would rise (if monetary policy does not react by reducing the money supply) and the exchange rate would devalue (purchasing power parity).To prevent this, the central bank must react. This reaction can be displayed with the button and is marked in blue. The central bank has two options. It can either sell foreign exchange to reduce the pressure to devalue. In doing so, it withdraws domestic money from the circulation and thus reduces the amount of current money ($\mathit{FX}\downarrow$, point 1). Alternatively, it can also directly reduce domestic credit, i.e. pursue a restrictive monetary policy ($\mathit{DC}\downarrow$, point 2). Both policies, or a combination of them, reduce the domestic money supply ($M=\mathit{DC}+\mathit{FX}\downarrow$). Consequently, the money demand curve shifts downwards until the pressure on prices is equalized. If the price level does not change, there is no pressure on the exchange rate and the new equilibrium with reduced income is established.

In the event of a positive growth shock, the opposite occurs. Deflation pressure creates appreciation pressure in the foreign exchange market, which the central bank counteracts by expanding the money supply, $M\uparrow$, because either $\mathit{DC}\uparrow$ (expansive monetary policy) or $\mathit{FX}\uparrow$ (buying foreign exchange reserves with newly created money).

Thus, fixed exchange rates force the central bank to pursue a monetary policy that acts as a multiplier for the effect of growth shocks. In a recession, the money supply is reduced, which additionally burdens the economy. Whereas in a boom the money supply is increased, which additionally fuels the economy. Therefore, the monetary policy reaction to exogenous growth shocks may even result in overheating.