On the fixed exchange rate

It appears that the idea of a fixed exchange rate has been risen, again.

Now the suggestion in here does take into account the impossible trinity – so it is theoretically possible.  We have:

  1. Monetary policy can impact on output and inflation,
  2. The exchange rate is fixed,
  3. Capital flows ARE LIMITED

That third one is the kicker.  Two issues I have here are:

  1. Limited capital flows implies that interest rates will rise (as for the previous interest rate there is a shortage of capital relative to demand).  This implies that our functioning monetary policy that controls inflation must have higher interest rates and lower output.
  2. Limiting capital flows is pretty difficult for a small open economy like New Zealand.

On the balance of evidence and theory I would say that I strongly disagree with this proposal.

Update:  BK Drinkwater comments here.  He rightly points out that a less volatile currency isn’t obviously a good thing – it is the movement in export prices and whether they represent actual changes in relative prices that matters.