Trace Reasoning Monetary Policy Enhanced a Flexible

Trace Reasoning Monetary Policy Enhanced a Flexible Exchange System

The paper will attempt to analyze why monetary policy tend to be more effective under flexible exchange rate system and less effective under fixed exchange system. Flexible exchange rates occurs when the exchange rate is allowed to move freely based on the demand and supply and the vice versa is true. The main argument in this case is flexible exchange rate is important because it allows forces of demand and supply to play their role without government interventions in situations where the monetary system is running well

It is laudable to note that monetary policy is an effective tool for policy makers in stabilizing the economy and for many countries this is such an important tool than the fiscal policies. In a flexible rate system, as we have mentioned above, the exchange rate is determined directly by market forces, and it liable to fluctuate continually, as dictated by market conditions and therefore this system may not appear appealing due to uncertainties of the present, especially to countries that are faced with uncertainties.

But what exactly what is monetary policy? This is the process by which the Central bank/Currency board or other regulatory committee of a country controls the supply of money often targeting a rate of interest for the purpose of promoting economic growth and stability. Monetary rate is controlled through actions such as increasing the interest rate, or changing the amount of money banks need to keep in the vault (bank reserves). On the other hand, the theory behind the exchange rate in a free market is as a result of the interaction of demand and supply of different currencies 'Countries with good monetary systems should use a flexible exchange system because it's more stable and in most cases does not contribute to inflation and current account deficit.' (John, 1975) In this way they have nothing to worry about any effects that may occur but should allow market forces to take their own course. For these countries they allow the forces of demand and supply to move freely instead of controlling or determining their exchange rate.

A flexible exchange system is claimed to lead to an independent monetary policy, where a country does not depend on others and thus a country is able to conduct properly its domestic economic affairs. 'In fact the monetary policy of a country is not limited or affected by the economic conditions of other countries. Fluctuating exchange rate system protects the domestic economy from the shocks produced by the disturbances generated in other countries.' (Dallas & Mark, 1985) Thus, we can assert that it acts as a shock absorber and protects the internal economy of a country from the disturbing effects from abroad/other countries. By the same reasoning, flexible exchange system also helps to diminish the international diffusion of our own domestic economic instability.

When we allow demand and supply to play their role in the market flexible exchange rate system promotes economic development which helps to promote employment in a country. (Francisco, 1997) indicates that the exchange rate can be charged in accordance with the requirement of the monetary policy of the country to achieve the intended or planned national goals. A more flexible rate is advisable in order to stabilize inflationary level and change the economic growth model. For instance, when domestic inflationary pressure is high, a proper appreciation of domestic currency can make imported goods less expensive.

According to Ching & Chau, (1984), their assertions in support of a flexible exchange rate system in enhancing monetary policy is that international practices have shown that a flexible exchange rate regime can help mitigate external economic turbulence, reinforce a nation's ability to withstand external crashes and stabilize the macro economy. The series of financial crises experienced in the world demonstrates that a rigid exchange rate is most vulnerable to speculative forces and can trigger monetary crises.

In another argument is that a flexible monetary exchange rate can also help improve the transmission mechanism of the monetary policy. There is the ability to adapt to market changes. With flexible exchange rate, market can be developed further an advantage for the monetary policies. By this therefore the government or the regulating policy of a country is able to stay in check with the supply of money into the markets and more important control the interest rates.

'In fact with the flexible exchange rates finacial institutions have strengthened their risk management, improved services and sped up product innovation. This has laid a micro-basis for monetary policy transmission.' (Francisco, 1997) These means that the forces of demand and supply have created healthy competition for these financial institutions which has led to better services and more great innovation in order to cater for demand and supply forces. Therefore the reasoning is that the improvement of the monetary policy transmission mechanism will play a positive role in strengthening the effectiveness of the monetary policy.

In another reasoning is that, if we have to promote international trade which is very important for countries then we have to allow for a flexible exchange rate system which will contribute to a flexible monetary policy that is essential for promoting international trade; this is because it does not permit exchange controls and promotes free trade. Restrictions on international trade are removed and there is free movement of capital and money between countries.

These characteristics of the flexible exchange rate system has vital implications both for the nature of our relationship with the global environment, and for the policy options available to the authorities in managing the economy. Flexible exchange rate ensures automatic balance of payments equilibrium, and thus it can liberate economic policy from the constraint, allowing the government to concentrate more easily on such internal issues as full employment and price stability. The distinguishing characteristics of a flexible exchange rate system is that the price of a currency adjusts automatically to whatever level it is required to equate the supply of and demand of that currency, thereby clearing the market.