Download The Interdependence of Markets

Using Interest Rates to Control both
Aggregate Demand and the Exchange Rate
A problem of one instrument and two targets
Assume that the central bank is worried about excessive growth in the money supply and
rising inflation. It thus decides to raise interest rates. One effect of these higher interest rates
its to attract foreign capital into the country (causing a capital account surplus) and thus drive
up the exchange rate. This makes imports cheaper and exports less competitive. This will
result in a current account deficit, which will match the capital account surplus.
Now let us assume that the government becomes worried about the damaging effect on
exports and wants to reduce the exchange rate. If it uses interest rates as the means of
achieving this it will have to lower them: lower interest rates will cause capital to flow out of
Britain and this will cause the rate of exchange to depreciate.
But there is a dilemma here. The government wants high interest rates to contain inflation
but low interest rates to help exporters. But of course it cannot have both high and low
interest rates at the same time! If interest rates are the government’s only weapon, one
objective will have to be sacrificed for the other.
Another example, but this time the reverse case, was when the UK was forced out of the
ERM in September 1992. In its attempt to stay in the ERM at a central rate of DM2.95 and
prevent speculation driving down the exchange rate, it was having to keep interest rates at
very high levels. But the economy was deep in recession and a lower interest rate would have
helped to stimulate investment and aggregate demand generally. On this occasion the
government wanted high interest rates to support the exchange rate, but low interest rates to
revive the economy. Once the country had left the ERM and the pound was allowed to float,
this allowed interest rates to be reduced. There was no longer any conflict.
These examples illustrate a rule in economic policy: you must have at least as many
instruments as targets. If you have two targets (e.g. low inflation and a low exchange rate)
you must have at least two policy instruments (e.g. interest rates and one other).
Another example we have come across is the two targets of low inflation and low
unemployment in the Keynesian model. Changes in aggregate demand cannot be used to
achieve both objectives simultaneously. Lower unemployment would require a more rapid
growth in aggregate demand, whereas lower inflation would require a less rapid growth in
aggregate demand. That is why it is argued that you require another instrument of policy as
well – such as supply-side policy.
Questions
1. Give some other examples of the impossibility of using one policy instrument to achieve
two policy objectives simultaneously.
2. If the central bank wanted to achieve a lower rate of inflation and also a higher
exchange rate, could it under these circumstances rely simply on the one policy
instrument of interest rates?