In a regime of , how could a central bank manage its monetary policy and its intervention policy in the markets exchanges? Why does it need foreign exchange reserves? The last 20 years have seen increased international interdependence due to reduced controls on capital flows between countries. Additionally, since the early 1970s, many countries have allowed greater flexibility in their exchange rates. These developments have raised several questions: How does the exchange rate regime affect the effectiveness of national monetary and fiscal policies undertaken by small open economies? In response to this question, many analysts, such as exchange rate and balance of payments analysts using the IS-LM model, have contributed to the rapid development of open economy models. An exchange rate regime is a description of the conditions under which the national government authorizes the determination of the exchange rate. There are three types of exchange rates: fixed, flexible and managed exchange rate. In a fixed exchange rate regime, national governments agree to maintain the convertibility of their currencies at a fixed exchange rate. Say no to plagiarism. Get a tailor-made essay on “Why violent video games should not be banned”?Get the original essayA currency is convertible if the government, acting through the central bank, agrees to buy or sell as much currencies that people want to exchange at the fixed exchange rate. Most central banks act as the government's banker, bank to banks, lender of last resort, and issuer of notes, while also overseeing the banking system and monetary policy. Monetary policy refers to attempts to manipulate the interest rate and money supply in order to bring about desired changes in the economy. The objectives of monetary policy are the same as those of economic policy in general. These are the maintenance of full employment, price stability, a satisfactory rate of economic growth and a balanced balance of payments. In a fixed exchange rate regime, governments agree to intervene in the foreign exchange market to maintain a given nominal exchange rate. It is important for the central bank to intervene to buy or sell currencies in an open market economy. It is completely understandable that foreigners buy assets in any country they want, quickly, with low transaction costs and in unlimited accounts due to the perfect mobility of capital. Perfect capital mobility means that the government cannot set independent targets for both the money supply and the exchange rate. It also implies that interest rates in any given country cannot deviate too far without causing capital flows that tend to bring yields back to the global level. Under fixed exchange rates, the government must accept a domestic money supply that makes domestic and foreign interest rates equal. It is understandable, from the above statement and also by looking at the Mundell-Fleming theorem, that there will be extreme capital flows even if there is a slight change in interest rates. Therefore, with perfect capital mobility, central banks cannot pursue independent monetary policy in a fixed exchange rate regime. For example, if a country increases its interest rate by tightening its monetary policy. Immediately, investors move their wealth to take advantage of the new rate and it would resulttherefore a massive influx of capital. The balance of payments will now show a gigantic surplus; foreigners attempt to purchase domestic assets, which tends to cause the exchange rate to appreciate and forces the central bank to intervene to keep the exchange rate constant. It buys foreign currency in exchange for national currency. This intervention takes place until interest rates are back in line with those of the world market. When price adjustment is slow, an increase in nominal money supply increases the real money supply in the short run and tends to reduce domestic interest rates. With perfect capital mobility, this leads to an outflow from the capital account until the domestic money supply is reduced to its original level and interest rates return to global levels. Domestic policy is therefore powerless in a fixed exchange rate regime when capital mobility is perfect. Looking at this point in terms of the IS-LM model of an open economy. Figure 1 shows that in the case of perfect capital mobility, the balance of payments can only be in equilibrium at the interest rate. Even at slightly higher or lower interest rates, capital flows are so massive that the balance of payments cannot be in equilibrium and the central bank must intervene to maintain the exchange rate. The intervention shifts the LM curve. Due to the decrease in the interest rate linked to monetary expansion, the economy moves from E to E'. But in E', there is strong pressure from the payments deficit on the exchange rate. The central bank must therefore intervene by selling foreign currency and receiving domestic currency. The LM curve therefore rises to its initial point E. Indeed, with perfect mobility of capital, the economy never reaches point E'. The reaction of capital flow is so large and rapid that the central bank is forced to reverse the initial expansion of the money supply as soon as it attempts to do so. This therefore proves that monetary policy under a fixed exchange rate regime is completely ineffective. However, fiscal policy is very effective under a fixed exchange rate regime. With the money supply unchanged, it shifts the IS curve up and to the right, tending to increase both the interest rate and the level of output. The higher the interest rate, the more it triggers an inflow of capital which would lead to an appreciation of the exchange rate. In order to maintain the exchange rate, the central bank must increase its money supply by further increasing revenues. As in Figure 2, equilibrium is restored when the money supply has increased enough to return the interest rate to its original position. Monetary policy is effective when subject to a flexible exchange rate regime. Figure 3 shows the actual intervention of the central bank in the foreign money market. Here, the dollar-pound exchange rate is fixed at e1. The fixed exchange rate, e1, would be the equilibrium rate if the supply curve was SS and the demand curve DD. Without an oversupply of books and an excess demand for books, no one would want to buy or sell books to the central bank. The market would clear itself. When demand for books in DD1, there is excess demand in AC. The Bank of England intervenes by providing AC pounds in exchange for dollars, which adds to the British foreign exchange reserve. Foreign exchange reserves constitute the stock of foreign currencies held by the national central bank. When demand reaches DD2, foreigners will buy fewer British goods, decreasing demand for sterling. The bank sells part of its foreign exchange reserves in exchange for pounds sterling. He demands books.