20.3 Monetary policy of the anchor country: Imported inflation and "harmful" monetary policy

A very important aspect of fixed exchange rates is the loss of autonomy in monetary policy. What does that mean? Well, the basic idea of autonomous monetary policy is to be able to influence economic developments by means of monetary policy decisions, such as the level of interest rates and the money supply, in order to achieve certain goals. For example, one objective may be to keep inflation at a low level or, in an economic downturn, to stimulate the economy by means of low interest rates. However, if the exchange rate is fixed, all other objectives are subordinated. The chart below shows that domestic monetary policy is then aligned with that of the anchor country. This means that, if conditions otherwise remain unchanged, the domestic interest rate must be lowered if the interest rate abroad is lowered, and the domestic interest rate must rise if the interest rate abroad rises. Domestic monetary policy thus imitates the monetary policy abroad. However, this may have unpleasant consequences, since foreign monetary policy obviously does not take into account the domestic economic cycle.

I) Expansive monetary policy abroad: If an expansive monetary policy is realized abroad – i.e. the money supply increases, interest rates are lowered, and possibly inflation rises – this must be imitated at home. This leads (if the money supply expansion does not coincidentally meet with an equally large growth spurt) to an increase in the domestic price level. This is referred to as imported inflation. We experienced this scenario in the 1970s, when the USA began to finance the Vietnam War via the printing press and subsequently inflation in Germany rose to over 7%. This spiral ended with the termination of the Bretton- Woods Agreement in 1973.

II) Restrictive monetary policy abroad: If a restrictive monetary policy is conducted abroad, i.e. a reduction in the money supply, an increase in interest rates, and possibly a decrease in inflation, this also must be imitated at home. If the domestic economy is not in a boom phase, the curbing effect of rising interest rates can be very strong and even trigger a recession. This scenario occurred, for example, during the tequila crisis in 1994/5. With the peso-dollar exchange rate fixed, the rise in interest rates in the USA led to capital outflows and rising interest rates in Mexico. This intensified the downturn in economic growth that had just begun and led to a real economic crisis, which then resulted in the imminent insolvency of the Mexican state and the abandonment of the fixed exchange rate.

The diagram above illustrates these relationships. To simplify, we assume that the (potential) impact on inflation of the monetary policy abroad determines the potential exchange rate. The slider enables to represent a monetary policy shock abroad.

In the case of a recessive monetary policy, this means that inflation is reduced abroad. As a result, the exchange rate would devalue (purchasing power parity). To prevent this, the central bank must react. This reaction can be displayed with the help of the button and is highlighted in blue. The central bank has two options. It can either sell foreign exchange to reduce the devaluation pressure. 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 case of an expansive monetary policy abroad, the opposite occurs. Inflation abroad creates appreciation pressure on 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 in exchange for newly created money). Thus, fixed exchange rates force the central bank to pursue a monetary policy that is not aligned with the domestic economic situation. This can cause both imported inflation and recession.