RDP 8908: Capital Flows and Exchange Rate Determination V. Implications for Monetary Policy

If we accept the common-sense proposition that the exchange rate is sensitive to domestic and foreign interest rates, and put aside the fact that this relationship cannot be established econometrically, the above conclusions are reasonably standard for a country with a floating exchange rate. The only distinguishing feature of the Australian exchange rate is its apparent long-run and short-run sensitivity to commodity prices or the terms of trade.

In a country with a floating exchange rate and interest sensitive capital movements, there is scope for a conflict between internal and external balance. In Australia's case, this usually takes place against a background of relatively high domestic inflation and a large current account deficit. The tight monetary policy likely to be required to help achieve the domestic anti-inflationary objective may push the exchange rate up and, therefore, slow down the balance of payments adjustment. However, in a world of flexible exchange rates and perfect capital mobility, there is a respectable body of opinion that says this should be the primary objective of monetary policy.[14] By and large, we accept the proposition that monetary policy should be directed primarily towards lowering the rate of inflation. The use of monetary policy to improve the current account deficit in the circumstances postulated is likely to be counter-productive. Attempts to hold down the nominal exchange rate are not likely to succeed in holding down the real exchange rate in the medium term; increases in the real exchange rate would simply be achieved through higher inflation. At the same time, fiscal and other policies (including wages policy) can contribute to the anti-inflation objective, as well as focussing on savings and investment incentives directed towards achieving external balance.[15]

If we add in the special feature of the sensitivity of the exchange rate to commodity prices, the basic proposition mentioned in the previous paragraph is strengthened. For example, Blundell-Wignall and Gregory have shown that a country that seeks to maintain price stability in the face of shocks to export prices should have a relatively flexible exchange rate (where price stability is defined as the minimisation of the variance of inflation from an inflation target). This result is derived from a model which they use to consider the optimal degree of exchange market intervention in a small commodity-exporting country. The model is specified to reflect some of the characteristics of the Australian economy.

The model result obtains because movements in the nominal exchange rate (in response to a commodity price shock) help to cushion some of the inflationary consequences of the change in commodity prices. For instance, a rise in commodity prices will boost domestic income and expenditure, raise the domestic price of exportables and tend to divert resources into the traded-goods sector and away from satisfying domestic demand. With a floating rate, the exchange rate will appreciate, which will act in the opposite direction to each of the three inflationary effects identified above. Similarly, a fall in commodity prices will dampen demand, reduce the domestic price of exportables and re-direct resources into satisfying domestic demand. A fall in the exchange rate would offset some of these deflationary effects.


This point was demonstrated by Mundell (1968); a more recent exposition is by Genberg and Swoboda (1987). They have shown that in such a world monetary policy should be assigned to an internal objective, while fiscal policy should be assigned to an external objective. [14]

If the authorities feel that there is strong evidence of overshooting of the exchange rate, there may also be a case for foreign exchange market intervention (sterilised), as in February 1989 in Australia. [15]