21.4.1 Monetary policy at fixed exchange rates

With fixed exchange rates, an expansion of the domestic credit supply (expansive monetary policy) does not change anything in the medium term except the composition of the money supply, which is not directly observable in the Mundell-Fleming model. Any change in domestic credit is ultimately offset by a reverse change in foreign exchange reserves via the foreign exchange market. If, after an increase in the money supply from $M_0$ to $M_1$, the return of the money supply to the level of equilibrium is initiated, it is called sterilization. The necessity to keep the exchange rate stable ultimately leads to a forced sterilization of any monetary policy measure that is not aimed at the compensation of other shocks. The following graph illustrates this problem.

The slider allows a monetary policy measure to be displayed. In the case of an expansive monetary policy, the money supply is increased and interest rates fall in order to sell the increased money supply on the market. Thus, the LM-curve shifts to the right, interest rates fall and GDP rises. As a result, the FF-curve shifts to the right and the interest rate gap, already described for flexible exchange rates, arises. Since the interest rate development in the domestic market (point A) and the new equilibrium interest rate in the foreign exchange market (point C) run in opposite directions, the interest rate gap and thus the pressure on the exchange rate is very large. In the event of a restrictive monetary policy, the signs of the changes would be reversed.

In the case of flexible exchange rates, the exchange rate would adjust in the short term through depreciation, GDP would continue to increase and interest rates would rise again moderately, see 21.3.1. In the case of fixed exchange rates, the central bank would have to absorb deprecation pressures in a different way. Either it reduces the money supply by reducing the domestic credit supply again, or it sells foreign exchange reserves against domestic currency and thus takes this money out of circulation (money on the central bank balance sheet is removed from the normal economic cycle). In both cases, the money supply and the deprecation pressure are reduced. The system is back in balance when the original money supply is reached. With fixed exchange rates, expansive monetary policy only works in the short term, if at all.