Fixed Exchange Rate Sticky Price Model

The Sticky Price Model with Fixed Exchange Rate

Under the fixed exchange rate sticky price model, monetary policy will be ineffective. In order to maintain the fixed exchange rate, the government would have to buy/sell foreign assets to offset any monetary or fiscal stimulus. The government/ central bank must also relinquish a fixed money supply because they will need to use the money supply to keep the exchange rate fixed (through open market operations). A small open economy cannot have control over the interest rate due to a prevailing world interest rate dominating, so when the exchange rate is fixed – all other monetary policy controls are forfeited.

Want to compare with a flexible exchange rate?

Now the economy can regain control over it’s money supply, and hence we use the IS LM Model. Here’s the IS-LM Open Economy Model

What if both prices and the exchange rate are flexible?

We go back to the Small Open Economy Model