21.4 Fixed exchange rates in the Mundell-Fleming model

As well the Mundell-Fleming model can be used to gain insights into fixed exchange rate regimes. In a fixed exchange rate regime, the central bank of a country commits to maintain the exchange rate at a certain, predetermined level $\overline{S}$.⁷ Suitable measures for this purpose include a forward-looking monetary policy that selects interest rates appropriately, foreign exchange market interventions and, as ultima ratio, restrictions on capital movements. This means, however, that monetary policy no longer autonomously follows its own goal, such as price level stability, but is coupled to the monetary policy of the anchor country through the exchange rate. We have already seen above that monetary and fiscal policy measures change the exchange rate. Therefore, if the central bank wants to keep the exchange rate stable at $\overline{S}$, it must use monetary policy measures to compensate for shocks affecting the exchange rate (e.g. inflation abroad, economic growth, but also the monetary policy of the foreign country).

In contrast to the monetary model (for details, see here), we do not present the composition of the money supply in its component version $M=\mathit{DC}+\mathit{FX}$, with the domestic credit stock $\mathit{DC}$ and the foreign exchange reserves $\mathit{FX}$. The money supply is only shown in aggregated form. Nevertheless, it is of course still valid that foreign exchange market interventions are limited by the available foreign exchange reserves. The money supply primarily acts via the $\mathit{LM}$-curve.