Exchange rate regimes can give nations varying levels of autonomy over monetary policy

August 20, 2020

Revised August 24, 2020. This version corrects some errors in country classifications in the originally published chart.

Exchange rate regimes can give nations varying levels of autonomy over monetary policy

Nations with a fully autonomous monetary policy can steer their domestic economies through their central banks. By lowering domestic interest rates to encourage consumption and investment, a central bank can boost employment and raise the inflation rate. On the other hand, a central bank can curb inflation and dampen employment by raising interest rates, thereby discouraging consumption and slowing investment.  

But nation states that use monetary policy to target inflation and employment have less control over currency exchange rates. Managed float and free float exchange rate regimes let the market play a leading role in determining the domestic currency’s exchange rate, with central banks intervening in foreign exchange markets to moderate exchange rate movements in the former system but sometimes at the cost of less monetary autonomy. If central bank monetary policy is prudent, market-determined exchange rates can protect the economy from some economic shocks. If monetary policy is erratic, or if international financial markets are volatile, then flexible exchange rate regimes can lead to financial, price, and employment instability. However, the more tightly a country uses monetary policy to control its exchange rate, the less able it is to deploy monetary policy to reach domestic objectives such as full employment and stable prices.

For example, Saudi Arabia pegs its currency to the US dollar to keep inflation at manageable levels and shield domestic consumers from price fluctuations on imported goods. But this practice also limits the country’s ability to use domestic monetary policy to respond to economic shocks. By contrast, Indonesia has adopted a managed float exchange rate regime. The rupiah floats against the US dollar, but the Indonesian central bank acts to smooth out fluctuations in the exchange rate, thereby limiting currency volatility. When these actions require the central bank to limit divergences between Indonesian and US interest rates, Indonesia’s monetary autonomy suffers.

This PIIE Chart was adapted from Maurice Obstfeld’s Working Paper, "Harry Johnson’s ‘case for flexible exchange rates’—50 years later.

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Maurice Obstfeld Senior Research Staff

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