Essay Example on Governments are required to choose between currency stability and national Economic








Under international monetary system governments are required to choose between currency stability and national economic autonomy As a result to choose between the two a country in order to retain nation autonomy would rather allow its currency to fluctuate In most major industrialized nations floating exchange rate system is prevailing since early 1970s whereas developing ones continue to have fixed exchange rate system To provide a stable system to importers exporters and investors and to limit speculation developing economies tend to utilize fixed exchange rates But neither the floating nor the fixed rate system is better than the other Rather it's a matter of recognizing that all exchange rate systems encompass a significant trade off between domestic economic economy and exchange rate stability Consequently when a country is forced to choose between a fixed exchange rates and domestic economic autonomy governments go for the latter Although fixed exchange rates provide exchange rate stability by stabilizing trade on one hand and help to achieve macroeconomic goals on the other hand but they obstruct government's ability to manage nation economic autonomy through monetary policy Secondly to maintain fixed exchange rates it needs domestic adjustments which are costly The country with trade deficit wishes to maintain fixed exchange rates have to face rising unemployment falling output and recession while the country with trade surplus for the same purpose of maintain fixed exchange rates has to deal with acute inflation

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Advanced industrialized countries therefore favor floating exchange rates because they are unwilling to forsake their national economic autonomy and also not willing to pay such costs in order to sustain fixed exchange rates Hence it depends on how governments view the tradeoff between fixed exchange rates and domestic economic autonomy Consequently the countries that desire domestic economic autonomy have to consider independent central banks in order to maintain low inflation As inflation carries potential large costs in terms of higher unemployment and less economic growth society can be benefitted by monetary policies that maintain low inflation consistently In this respect independent central banks come into play Most governments are unable to achieve and maintain low inflation and thus establish credible commitment mechanisms for this purpose in the form of fixed exchange rates and independent central banks In theory both mechanism provide credible commitment towards maintain low inflation but only independent central banks can do actually in practice Firstly Independent central banks can decide freely what economic goals to pursue and how to use monetary policies to pursue such goals without the interference of governments Secondly fixed exchange rates cannot solve time consistency problem Independent central banks solve this problem by preventing the governments to pursue short term objectives They take the use of monetary policy completely out of control of politicians who now cannot set monetary policy for their short term political aims In this way an independent central bank ensures low inflation and strong economic growth Therefore a country which wants to retain domestic economic autonomy consider only central bank independence because still the government does have the power over exchange rates system Exchange rates and monetary policy options can be explained by three society based models of monetary and exchange rates politics  

The electoral model it argues that government s exchange rate policy usually determine its decision concerning monetary policy According to this model governments are more concerned with monetary policy autonomy They would maintain fixed exchange rates only when it allows monetary policy to accomplish domestic economic objectives The need to win elections reelections shape these economic objectives and governments pursue monetary policy accordingly Usually governments adopt floating exchange rates in order to maintain monetary policy autonomy It is because macroeconomic conditions decide the government's electoral fortune in two significant ways pocketbook voters this means that people vote in favor or against the government on the basis of their personal gains The person would vote in favor whose income rose and one who lost his job tend to vote in against Sociotropic model people would support ton the basis of overall performance of the government that is low inflation less unemployment and economic stability So they become less willing to tighten their monetary policy for the sake of fixed exchange rates 2

Partisan model It assets the same assumptions as electoral model with one distinction It argues that different political parties have different macroeconomic objectives Those which want to limit inflation use monetary policy in line with floating exchange rates while other use fixed exchange rates in order to reduce unemployment 3 Sectoral model this model assumes that interest groups import competing producers export oriented producers non trade goods producers and the financial services industry preferences shape exchange rates and monetary policies Some prefer strong currency and some weak currency whilst some other groups fixed exchange rates and some prefer floating exchange rates These groups lobby the government on the basis of their preferences they possess Internationally the countries have abandoned the use of monetary policy and have placed monetary policy into the hands of officials of independent central banks who are completely secured against any political push and pull Often the groups of central banks work together in a coordinated way in order to maintain price stability and strong economic growth of the countries

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