Discuss the pros and cons of floating against fixed exchange rate Essay

Discuss the pros and cons of floating against fixed exchange rate regime using the Mundell-Fleming and the Dornbusch models - Essay Example With increased supply of money, people will transform that non interest-bearing asset, money into interest bearing assets, bonds. Therefore, the demand for bonds will rise. That will lead to an increase in bond price. (Obstfeld and Rogoff, 1984) Due to the inverse relationship between bond price and market rate of interest, the market rate of interest will fall. This fall in market rate of interest will be followed by a huge capital outflow. Now, same amount of domestic money will run after less amount of foreign currency resulting in domestic currency depreciation. To maintain the domestic currency at a fixed level, the central bank will have to sell its foreign currency reserve in exchange of domestic money. This phenomenon will lead to a contraction in money supply and it will continue till the market rate of interest rises to its initial level, that is, till the initial expansionary monetary policy gets fully crowded out. (Obstfeld, 2000) From the above, it is clear that the monetary policy will be fully ineffective under fixed exchange rate regime. Now, if the government chooses a fiscal expansion through a rise in government expenditure, then income rises. With a rise in income, transaction demand for money increases. With a rise in transaction demand for money, people will sell bonds in order to meet that increased transaction demand. So, bond supply will rise, bond price will fall and market rate of interest will rise. With the increase in market rate of interest a huge capital inflow will occur, resulting in a currency appreciation. In order to maintain the fixed exchange rate the central bank will purchase that extra supply of foreign exchange. It will result in an increase in money supply, increasing the demand for bond, which will eventually lower the initial rise in interest rate to its initial level. However income will be higher than the initial level. So fiscal policy will