Aveneu Park, Starling, Australia

Under economic autonomy, governments go for the latter. Although

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. 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.

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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:

1. 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, nontrade 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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