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:
- Monetary policy can impact on output and inflation,
- The exchange rate is fixed,
- Capital flows ARE LIMITED
That third one is the kicker. Two issues I have here are:
- 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.
- 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.