[PDF Notes] Short Essay on the Exchange and Price Stability

Exchange stability and price stability are the two conflicting objectives of monetary policy. Both of these objectives cannot be achieved simultaneously; any one of these objectives can be achieved only by sacrificing the other.

For example, under gold standard, the objective of exchange stability was achieved, but the objective of price stability remained unfulfilled. There are, however, certain cases in which the two objectives of exchange stability and price stability become complementary and can be achieved together:

(i) Under gold standard, both these objectives can be achieved if the rules of the game are followed strictly. For example, if a country has sufficient gold reserves, it need not reduce money supply if there is outflow of gold as a result of unfavorable balance of payments.

Similarly, if there is inflow of gold due to favourable balance of payments, the country can immobilize the influx of gold and does not allow it to have inflationary effect on domestic prices. Thus, in both these situations, the external exchange stability is achieved without disturbing the internal price stability.

(ii) Both the objectives can also be achieved together when the policy of exchange stabilisation coincides with the policy of price stabilisation. For example, under gold standard, if there is an outflow of gold due to unfavorable balance of payments, the country must contract money supply to maintain exchange stability.

But, if the country in question is already operating at the full employment level and the internal prices are rising, the contraction of money supply will lead to the achievement of both exchange stability and price stability.

Similarly, a policy of monetary expansion will be able to achieve both exchange stability and price stability if there is favourable balance of payments and the country is also experiencing deflationary situation, requiring an increase in the money supply to stimulate investment, employment and prices.

(iii) Mendel has suggested a strategy to reconcile the objectives of exchange and price stability by assigning different objectives to monetary and fiscal policy.

According to him, expansionary fiscal policy should be used to move the economy ahead with price stability and tight monetary policy should be used to keep interest rates high, thereby attracting the capital inflows necessary for maintaining the balances of payment equilibrium without depressing the exchanges rate.

This view is based on the assumption that the expansionary fiscal policy will be able to more than offset the restrictive effects on the domestic economy of the tight monetary policy.

(iv) In modern times, the objectives of exchange stability and price stability are reconciled through international monetary cooperation.

The task of maintaining exchange stability has been entrusted to the International Monetary Fund (IMF) of which most of the countries are members. On the other hand, the objective of internal price stability is achieved by individual countries through their internal monetary policies.

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