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It is a trite but true assertion of international monetary economics that the exchange rate is an open economy’s most important price. The United States has become ever more open to trade since the end of World War II, as Robert Feenstra documents in his article in this symposium. Exchange rate movements therefore have increasingly become a cause for public and official concern.

Fundamental Tradeoff

In most of the world’s economies, the exchange rate is a key instrument, target, or indicator for monetary policy. An open capital market, however, deprives a country’s government of the ability simultaneously to target its exchange rate and to use monetary policy in pursuit of other economic objectives. As an example, consider Austria, which for more than two decades has pegged the exchange rate between its currency, the schilling, and the German mark. Since market participants understand that the exchange rate will not change by more than a few basis points, nominal interest rates in Austria must closely match those in Germany. The rates are kept in line by arbitrageurs who would massively borrow in the currency with the lower interest rate and lend in the currency with the higher interest rate, confident that their gains will not be erased by a movement of the exchange rate. But equality of interest rates also means that Austria cannot conduct a monetary policy independent of Germany’s; both Austria’s exchange rate and interest rate will be determined exogenously. Since it is Austria (and not Germany) that is pegging the exchange rate, the Austrian central bank has only one monetary role, to offset any incipient change in the schilling’s exchange value against the mark.

Austria can regain an independent monetary policy in two ways. If it could prohibit any cross-border financial transactions, Austria would cut off the arbitrageurs and decouple its interest rate from Germany’s, but could still maintain the fixed exchange rate. In that case, Austria might unilaterally lower its interest rates, for example, but investors no longer would have the right to move funds from Vienna to Frankfurt in response to the resulting return differential. Pressures in the foreign exchange market would be limited to mark demands from Austrian importers and from exporters to Austria wishing to convert their schilling earnings into marks. Any exchange-rate effect of these trade-driven demands for marks, which are orders of magnitude below the potential demands associated with international financial flows, could normally be offset by sales of Austrian official mark reserves as necessary.