Developing countries often face structural rigidities, particularly in the labour and land markets, that keep growth below its true potential but cannot be addressed by monetary policy. Meanwhile, the “fear of floating” limits, in practice, the flexibility of exchange rates. Additionally, the lack of reserve currency status exacerbates external vulnerabilities, making these economies more susceptible to balance-of-payments pressures. These factors necessitate a reassessment of the relative roles of monetary and fiscal policy in achieving macroeconomic stability for developing countries.
This paper critically examines the use of monetary policy in Sri Lanka, arguing that structural and external constraints limit its role. The Mundell-Fleming trilemma highlights trade-offs between exchange rate management, capital mobility, and monetary policy autonomy. Mismanaging the balance in the trilemma is a source of instability. The paper argues that monetary policy should be assigned a restricted role: to stabilize the value of the currency in the external market. If the stabilization of output is desired, fiscal policy should be utilized.
The evolution of money
No discussion of monetary policy can begin without a proper understanding of money: what it is, the role it plays in an economy and the important attributes that enable it to play that role. Money is a phenomenon that has evolved throughout human history alongside the patterns of trade and exchange that have led to the development of the market economy.
In the journey towards the market economy, money preceded other important developments such as contracts, bookkeeping, and banking, but forms of money co-evolved with these. Some of these later developments have obscured the nature and properties of money, so an examination of its origins is needed to clear the misconceptions that prevail today.
Simply put, money is the most widely accepted commodity in exchange. It arose to overcome the limitations of barter, the need for a ‘double coincidence of wants’. Over time, certain widely accepted goods emerged to become common media of exchange.
“A medium of exchange is a good which people acquire neither for their own consumption nor for employment in their own production activities, but with the intention of exchanging it at a later date against those goods which they want to use either for consumption or for production.”(Mises)[1]
Different commodities were employed at various times as media of exchange, but most were eliminated.
“Thus, the requirements of the market have gradually led to the selection of certain commodities as common media of exchange. The group of commodities from which these were drawn was originally large and differed from country to country, but it has more and more contracted. Whenever a direct exchange seemed out of the question, each of the parties to a transaction would naturally endeavor to exchange his superfluous commodities, not merely for more marketable commodities in general, but for the most marketable commodities; and among these again he would naturally prefer whichever particular commodity was the most marketable of all.
The greater the marketability of the goods first acquired in indirect exchange, the greater would be the prospect of being able to reach the ultimate objective without further maneuvering. Thus, there would be an inevitable tendency for the less marketable of the series of goods used as media of exchange to be one by one rejected until at last only a single commodity remained, which was universally employed as a medium of exchange; in a word, money…A long evolution eliminated the greater part of these commodities from the monetary function. Only two, the precious metals gold and silver, remained. ”(Mises)[2]
At first, people exchanged the metals themselves, shapeless pieces or early standardized ingots of crude metal. Later, metal pieces were stamped for weight, and the first proto-coins came about, and later, paper money.
“The first true paper money was produced by the Jin Dynasty (1115-1234) of China in 1189. However, it was not used in the West until 1661, when the Stockholm Banco issued credit notes in an attempt to back the value of Swedish plate money .”[3]
It is important to remember that although the forms of money changed from ingots to coins to paper, the substance remained unchanged. Bank notes were a medium for transferring money, not money in its own right. The paper or token coins were only a claim on money. Individuals could take their paper notes to the bank to redeem them for gold or silver. This was the norm in most instances until the 20th century.
The importance of an anchor in preserving the value of money
The fundamental tenet of the traditional gold standard was that gold was the only legitimate form of money. Each unit of currency that a nation created had to be backed by a particular amount of gold. As a result, the supply of money was controlled, and currency values were fixed.
An anchor is critical because money can be exchanged for goods of value; in the absence of a firm anchor, there is an ever-present temptation to adulterate the coinage or issue more notes than the available bullion, a frequent practice during times of war. Nevertheless, after each inflationary episode, there was an eventual return to metal, and prices would also fall to the previous level, as illustrated in the charts below.
U.K. Price Level, 1800–1992
“The chart begins in 1800, following a period of great turmoil in the British financial system. Effectively, the British were off the gold standard during the Napoleonic Era and did not return to specie until 1819. From 1820 through the early days of World War I, the United Kingdom adhered firmly to the gold standard and experienced nearly 100 years of comparative price-level stability. Note, however, that while the U.K. price level in 1820 nearly matches that in 1920, the time path was a volatile one;….Once the British left the gold standard, the fixed nominal anchor was removed from their monetary system, and the tendency for prices of goods to return to a baseline level was ended. After 1940, in the U.K. experience, it was typical for the inflation rate rather than the price level to return to a normal level.”(IMF, 1994) [Emphasis added][4]. A similar chart for the US exhibits the same pattern.
U.S. Price Level, 1800–1992
“The U.S. price level, beginning in 1800 and ending in 1992…reveals the same remarkable difference between pre-World War II and post-World War II price-level behavior that is seen in [the UK chart]….it is apparent that prices in the prewar period had a tendency to return to a baseline level, with periods of deflation following periods of inflation….Such price-level reversion is a key characteristic of a specie standard, including a specie standard that is temporarily suspended and later reinstated at the same parity.”[Emphasis added][5]
The quality of money is determined by the quality of its anchor.
The period 1880 to 1914 marked the era of the classical gold standard where the majority of countries adhered (in varying degrees) to gold. It was also a period of unprecedented economic growth with relatively free trade in goods, labour, and capital. This broke down during World War I, as the major belligerents resorted to inflationary finance. It was briefly reinstated in 1925 but broke down again in 1931.
Up to the middle of the 20th century, the association between gold and the value of paper money remained strong; the only acceptable deviation was the exigencies of war. As long as this association remained in the public mind, governments were compelled to return to gold. This was to change in the Keynesian revolution and the events that followed.
Keynes, one of the architects of Bretton Woods, was deeply influenced by the Great Depression and believed that the government should intervene in an economic crisis to prevent a recession. He believed that the restraints imposed by the gold standard made it difficult for governments to do so. The war boom of 1939-45 ended the Great Depression and seemingly delivered proof of his ideas. More insidiously, for governments dependent on the popular vote, the academic justification for greater interventionism proved to be politically expedient. Economists who advocated these ideas and politicians who accepted them believed that a government could now seemingly offer greater prosperity at little cost; the limits of debt and taxes could no longer hold back progress.
In 1945, Keynesian ideas had not yet penetrated very deeply into the public imagination, and gold remained the basis of money. Therefore, as in the previous instances of departure from gold during wartime, there was an attempt to return to it in peace. Under the Bretton Woods agreement, the convertibility of the US Dollar to gold was guaranteed, and all other currencies were pegged to it, creating a gold exchange standard. The only country that was on the gold standard was the USA, but as all other currencies were pegged to the US dollar, the world as a whole was on a de facto gold standard. The system contained a fatal flaw.
This was mutual incompatibility between the objectives of maintaining the convertibility of the US dollar to gold (on which the system of fixed exchange rates depended) and permitting domestic “demand management” to preserve full employment.
Bretton Woods was designed to maintain a system of fixed exchange rates but, at the same time, under the influence of Keynes, allow countries some flexibility in domestic “demand management” to preserve full employment. An independent monetary policy would enable a government to increase the money supply to prop up aggregate demand, thus stimulating economic activity. The problem is that if the money supply increases without gold reserves to back it, the convertibility to gold can no longer be guaranteed.
The incompatibility was recognized at the time and was to be managed by a combination of capital controls and the mediating role of the IMF to manage the adjustment between those economies with balance-of-payments surpluses and those with balance-of-payments deficits. The IMF would make short-term loans to countries to cover the difficulties of adjusting to the temporary balance-of-payments.
Only the USA committed to convert dollars to gold on demand from other central banks, so the functioning of the system depended on the USA following the discipline imposed by the gold standard. Countries could experiment with expansionary monetary policy, but not the USA.
The US adopted expansionary policies in the 1960s.
“As Keynesian economics became the dominant paradigm, mainstream economists and policy makers came to believe that the Federal Reserve could reduce unemployment through monetary expansion with an acceptable impact on inflation.”(Rockoff, 2015)[6]
Events moved swiftly after Lyndon Johnson became president. He moved ambitiously to create his Great Society with bold initiatives to help the poor and middle class. In January 1964, Johnson declared his War on Poverty, but in August 1964 came the Gulf of Tonkin Resolution authorizing the use of force against North Vietnam.”(Rockoff, 2015)[7]
When the Federal Reserve attempted to act, it came under political pressure.
….Early in December 1965, the Federal Reserve announced an increase in the discount rate (the rate at which the Federal Reserve lends to member banks) from 4 to 4.5 percent. Martin knew that Johnson was opposed to any increase in rates but felt that the time to act had arrived. Johnson publicly condemned the move (New York Times, December 6, 1965, 1). “I regret, as do most Americans, any action that raises the cost of credit, particularly for homes, schools, hospitals and factories”(Rockoff, 2015)[8]. [Emphasis added]
The Federal Reserve compromised and,
“did not follow a sharply restrictive monetary policy. Open market operations continued to be expansionary and high-powered money, and the money supply continued to grow…. Martin’s understanding that the Federal Reserve was independent within (not from) the government.”(Rockoff, 2015)[9]
The consequence of money printing is the loss of reserves, which, in this case, was gold. US gold reserves began to erode from the 1960s.
“In March 1961, the world and U.S. monetary gold stocks were $40.6 and $17.4 billion, respectively. By the end of December 1967, these amounts had reached $41.6 and $12 billion, respectively, and the U.S. gold stock fell to a low point of $10.7 billion at the end of March 1968” (Garber, 1991)[10]
The US reacted by trying to “fix” the gold market.
“Starting from 1960, efforts to patch perceived deficiencies in the operation of the system assumed the form of perfecting interventions in the private gold market through the organization of the Gold Pool and the establishment of various formal liquidity-increasing techniques-the General Arrangements to Borrow (GAB), currency swaps among central banks, and special drawing rights (SDRs). Essentially, these were new forms of lines of credit jerry-built atop the preexisting credit lines like intergovernmental and private bank loans and drawings under the IMF’s original credit provisions. Analogous to interbank credit lines in a domestic banking system, such changes would have tended to reduce official demand for foreign reserves.”(Garber, 1991)[11]
As these interventions dealt with symptoms rather than the underlying causes, they were doomed to fail. Matters came to a head in 1971, and the US suspended the conversion of the US dollar to gold.
Under the classical gold standard, gold provided an excellent anchor, but the link to gold was weaker under the Bretton Woods gold exchange standard and was lost completely when the US suspended the convertibility of the dollar. This upended the very basis of all international trade. It was a huge shock to the system; Economist Benn Steil summed it up:
“The Bretton Woods monetary system was finished. Though the bond between money and gold had been fraying for nearly sixty years, it had, throughout most of the world and two and a half millennia of history, been one that had only been severed as a temporary expedient in times of crisis. This time was different. The dollar was, in essence, the last ship moored to gold, with all the rest of the world’s currencies on board, and the United States was cutting the anchor and sailing off for good.” (Steil, 2013, cited in Pollock, 2023)[12]
The demise of Bretton Woods ushered in a period of exchange rate volatility, inflation, low growth, trade conflicts and crises of more than two decades.
Advantages of the gold standard
The gold standard ensured that the value of money remained stable. This created a predictable business environment that encouraged domestic trade and investment. It also provided fixed exchange rates between countries, which instilled confidence, enabling greater international trade.
As Murray Rothbard noted: “The world was on a gold standard, which meant that each national currency (the dollar, pound, franc, etc.) was merely a name for a certain definite weight of gold. The “dollar,” for example, was defined as 1/20 of a gold ounce, the pound sterling as slightly less than 1/4 of a gold ounce…. This meant that the “exchange rates” between various national currencies were fixed, not because they were arbitrarily controlled by government, but in the same way that one pound of weight is defined as being equal to sixteen ounces”[13].
The key was the pledge to maintain convertibility to gold, a rule that bound the hands of policymakers to prevent them from following inflationary discretionary policies. This ensured that the money supply and, hence, the price level, would not vary much.
The search for a new anchor
The ending of the link to gold meant that a new anchor was necessary.
Over the past two centuries, three main types of nominal anchors for money have been employed. The first, fixed nominal anchors, involve pegging a currency to the price of commodities, such as gold or silver, which stabilized nominal prices over the long term. The second type, moving nominal anchors, targets variables like monetary supply, inflation, or nominal income. These systems aim for medium- to long-term stability in inflation and other nominal rates without reverting to a fixed price level. The third type, exchange rate arrangements, involves managing or pegging a currency’s value relative to another currency, often through fixed or controlled parity systems. These arrangements effectively share a nominal anchor across participating countries[14].
The most common anchors today are of the second or third type. The received wisdom in academia is not generally in favour of fixed exchange rates[15], so the majority of countries claim to run floating exchange rates.
Actual practice, however, differs from theory.
The ‘fear of floating’
Academic theory in the Keynesian framework favours floating exchange rates because it permits countries to employ monetary policy to avoid recessions – cyclical downturns that supposedly arise from a fall in aggregate demand. An important paper by Calvo and Reinhart (2002) discovered a gap between theory and practice in exchange rate policy.
They found that many developing countries (and even some developed countries) are reluctant to allow fully floating currencies, even while they attempt to run an independent monetary policy, a phenomenon termed a ‘fear of floating’(Calvo and Reinhart, 2000) [16]. Later research by Rizvi et al (2017) confirmed that this[17] is still the case.
Calvo and Reinhart (2002) also note that while a pure float is an artifact of economics textbooks, the US dollar, Deutsche Mark (and now the euro) and the Yen are the only currencies that are “as free to float as any currency has ever been allowed to float[18] ”.All of these currencies happen to be currencies of reserve.
All the other countries that claim to float seem to permit only limited flexibility in their exchange rates, using a combination of direct interventions in the foreign exchange markets and interest rate policy to manage the exchange rate.
The puzzle is why so many countries are reluctant to float. The widespread reluctance to float in practice and the divergence in attitudes to floating between countries that enjoy currencies of reserve and those that do not point to some important truths.
Calvo and Reinhart posit that the fear of floating, more generally, fear of large currency swings, is pervasive for a variety of reasons, particularly among emerging market countries. One reason is liability dollarization: the cost of repayment of foreign debt in local currency increases if the currency depreciates. The other is the output cost associated with exchange rate fluctuations, which can be heavy.
Exchange rate volatility can disrupt domestic production; traders in imported goods may face shrinking profit margins and reduced demand and may scale back operations. Manufacturers face higher input costs, including rising energy costs, which will also affect the service sector. All sectors face difficulty with pricing and budgeting decisions.
Volatile prices can deter customer demand and erode trust, reducing overall sales. Long-term contracts with fixed prices become risky as traders bear the brunt of exchange rate shifts. Profit margins become unpredictable, especially if pricing adjustments lag behind cost increases. All this uncertainty diminishes confidence, which deters investment.
Currency devaluations are also known to carry political costs.
“In a widely quoted statistic, Cooper (1971) found that political leaders often lose office in the year following devaluation. Frankel (2005) updated the estimate and verified statistical significance: A political leader in a developing country is almost twice as likely to lose office in the six months following a currency crash as otherwise.” (Frankel, 2010) [19]
Thus, there are clear reasons why countries prefer stability in their exchange rates. Good examples of this are found in the developments that took place in Europe after 1971.
The collapse of the Bretton Woods system produced a wave of instability with respect to foreign exchange. In 1972, the countries of the EEC tried to minimize exchange rate fluctuations among their currencies through a mechanism termed the ‘Snake’. This failed in a couple of years as the Italian, British, Irish and French currencies were undermined by galloping inflation[20]. In 1979, Europe again attempted to stabilize exchange rates through the European Monetary System, which attempted to limit fluctuations to +/- 2.25% against a central reference rate[21]. This was partially successful, but the Sterling and the Italian Lira were removed from the system altogether, and several other currencies were devalued. This arrangement evolved into the Euro -equivalent to a single fixed exchange rate across the EEC.
The Nordic countries, which were outside the EEC also adopted a policy of essentially fixed exchange rates from 1973.
“The Nordic EFTA members have decided against free floating mainly out of fear of the potentially destabilizing effects of excessive volatility of exchange rates on trade, investment, employment, and inflation…..they have chosen to peg the exchange rates of their currencies individually to different trade-weighted or payments-weighted baskets of foreign currencies”(Gylfason. 1990)[22]
The advantage of a reserve currency
A currency of reserve has some unique advantages that enable the adoption of a fully floating exchange rate.
The closure of the ‘gold window’ in 1971 was a less painful option for the USA due to the unique position of the US dollar as the currency of reserve. In 1945, the value of the dollar was based on the US holdings of gold, but in the decades that followed, other countries came to use the dollar as the principal reserve asset. When the US abruptly suspended the convertibility to gold, there were few alternatives, so other countries were forced to maintain most of their holdings of US dollars. This meant that the US was able to avoid the consequences of a balance of payments deficit.
“The United States…pays the creditor country dollars, which end up with its central bank. But the dollars are of no use in Bonn, or in Tokyo, or in Paris. The very same day, they are re-lent to the New York money market… So the key currency country never feels the effect of a deficit in its balance of payments”(Rueff, 1972)[23].
“Thus, the United States did not have to settle that part of their balance-of-payments deficit with other countries. Everything took place on the monetary plane just as if the deficit had not existed…..The discovery of this secret profoundly modified the psychology of nations. It allowed countries lucky enough to have a boomerang currency to disregard the internal consequences that would have resulted from a balance-of-payments deficit under the gold standard”(Rueff, 1972)[24]
“…The role of the dollar allowed the US to be a “system maker and privilege taker” (Mastanduno, 2009, cited in Yap 2011)
Countries that use reserve currencies continue to enjoy this advantage today.
The advantages of a fixed exchange rate
Money oils the wheels of trade; it is obvious that it performs its functions best when its value is stable. If the value of money fluctuates widely, it undermines its fundamental purpose. A simplistic example drives this point home.
Imagine being contacted by a broker about a 2,500-square-foot house, only to visit and find a house half the size. The prospective buyer would have very little trust in the broker. This is purely hypothetical, given that a foot is a foot. Since its definition is unchanging, 2,500 square feet means the same today as it did 20 years ago.
Whatever the level of trust buyers have in their brokers, square footage will never be a factor; that is, unless the length of the foot is allowed to “float,” and its length declines. Suddenly, 2,500 square feet could very well mean 1,500 square feet in real terms, and trust in brokers will plummet.
This illustrates the effect of an unstable currency. The exchange rate is only a reflection of the buying power of money. Sound money has underpinned sustained growth in Singapore, Hong Kong and West Germany.
Countries that enjoy currencies of reserve can adopt a free-floating exchange rate while avoiding many of the problems that other countries would face under a similar arrangement. Reserve currencies are those issued by central banks that have gained high levels of credibility and are thus widely used in international trade and held in significant quantities as reserves. These currencies experience strong demand, so they do not experience violent movement. For example, the U.S. can engage in quantitative easing without the same risk of currency collapse faced by non-reserve issuers.
Other countries, particularly developing countries, under floating exchange rates must contemplate steady depreciation, sudden collapse or wide swings in the foreign exchange markets, none of which are particularly attractive.
A fixed exchange rate provides a similar commitment on convertibility (although to an anchor currency instead of gold) and shares many of the advantages of the gold standard; it reduces transaction costs and exchange rate uncertainty in international trade. For small economies, changes in the exchange rate can have an important influence on prices. It is not only the prices of imports but also import-competing goods and local goods that are tradable internationally. When the currency depreciates, local prices of these goods and services tend to rise quite quickly and by a similar amount as the depreciation of the exchange rate.
The principal argument advanced against a fixed exchange rate is that it deprives the central bank of its ability to use monetary policy to stimulate the economy. This, in our view, is not a serious drawback. Marvin Goodfriend and Robert G. King (1988)[25] highlight the traditional monetarist arguments on the difficulties with monetary policy originating with Milton Friedman and Karl Brunner, which hold that
“monetary policy has a powerful but frequently destabilizing impact on economic activity. From this perspective, monetary policy exacerbates cyclical volatility because
(1) its effects are subject to long and variable lags, which makes the timing of monetary policy actions difficult,
(2) it is difficult for policymakers to assess promptly the state of economic activity due to problems of inference about the dominant forces that drive the economy in a given period, and
(3) the policymaker’s focus on smoothing nominal interest rates against cyclical changes in real rates generally leads monetary aggregates to be procylical.”
This is especially so when set against the political and social costs that arise from currency depreciation. As Mishkin points out:
“For emerging market countries, it is far less clear that these countries lose much by giving up an independent monetary policy when they target exchange rates. Because many emerging market countries have not developed the political or monetary institutions that result in the ability to use discretionary monetary policy successfully, they may have little to gain from an independent monetary policy but a lot to lose. Thus, they would be better off by, in effect, adopting the monetary policy of a country like the United States through targeting exchange rates than in pursuing their own independent policy. Indeed, this is one of the reasons that so many emerging market countries have adopted exchange-rate targeting.”[26]
Fixed exchange rates are claimed to be unstable, but this only occurs if activist monetary policy is attempted under a fixed peg. As long as the monetary policy is targeted at maintaining the fixed exchange rate, the peg will be stable.
A fixed exchange rate in Sri Lanka’s current context
The economy is still recovering from the economic crisis. While the Central Bank has done a commendable job in restoring stability, the recovery is precarious. The adjustment has been very painful. The increase in taxes, administered prices (fuel, gas, electricity, water) and the devaluation of the currency have squeezed household budgets. The devaluation of the currency, although necessary, has been a major cause of the higher cost of living as it has raised the prices of imported consumer items and inputs for domestically produced items. It is, therefore, critically important to avoid inflicting further suffering on people. Any further depreciation of the currency will immediately raise the cost of living.
One of the most important aspects in attracting investment and stimulating economic activity is confidence. Confidence arises from predictability in the policy environment; the greater the predictability, the greater the confidence. If taxes, laws, regulations and other policies change frequently, especially when these changes are sudden and ad-hoc, it destroys confidence.
The exchange rate is a clearly visible indicator that is observed by all economic actors. It has a direct effect on the cost of living; apart from food and consumer items, key inputs – energy, raw materials and components are imported. A stable exchange rate allows importers, exporters, and investors to plan without worrying about currency moves.
The crisis has shaken investor confidence, and the collapse of the rupee is seared into the subconscious of the population. In this context, a stable exchange rate can also play an important signalling role in restoring confidence.
Adopting a fixed exchange rate means giving up an independent monetary policy. Theoretically, monetary policy can be used to boost growth, which may be used to dampen cyclical downturns in the economy but can result in balance of payments difficulties, which has been Sri Lanka’s experience.
Sri Lanka’s growth performance in the past has been episodic, a major problem being recurrent balance of payments crises. Short spurts of growth are followed by a crisis, an IMF programme and a slowdown as the IMF stabilization policies take effect. When growth picks up, the cycle is repeated, and Sri Lanka is now on its 17th IMF programme.
“The initial analysis found that recent growth and the sustainability of growth moving forward are constrained by weakness in Sri Lanka’s balance of payments, where a trade imbalance combined with low levels of foreign direct investment effectively puts a speed limit on economic growth.”(Hausmann, 2016)[27]
Since growth is constrained by the balance of payments, more sustained growth means avoiding BoP problems, which implies a limited role for monetary policy. If stabilization measures are deemed necessary, they should be implemented through fiscal policy.
Conclusion
Floating exchange rates emerged accidentally, following the collapse of the Bretton Woods system. Exchange rates were floated only because there did not seem to be an alternative. The disadvantages of a wobbly currency are obvious, which is why the countries of Europe worked towards limiting the fluctuation between their currencies, eventually culminating in the single currency. The only countries that practice truly free floats are those that are the least affected by the negative consequences: the countries that enjoy currencies of reserve. Most other countries manage their exchange rate in practice, although they may claim to float.
Sri Lanka has also tried to manage its exchange rate in the past but suffered periodic balance of payments crises, which have been blamed on the peg. The problem with the peg arises not because of the peg itself but in the conflict between activist monetary policy and a fixed exchange rate: the same conflict that led to the breakdown of Bretton Woods. If the Central Bank allows interest rates to be market-determined, no conflict will arise, and the peg will be stable.
Sri Lanka moved to flexible exchange rates around 2012[28]. Under the flexible exchange rate, the rupee slid from 131 to the dollar to 182 between 2015-19[29] and may have contributed to the fall of the government in 2019. Since 2012, the rupee has fallen from around 113 to the US dollar. If the country persists with the market-determined flexible exchange rate while trying to control interest rates artificially, we can expect a repeat of this.
The interest rate is the price of money. It is one of the most important prices in the economy; it determines the savings, investment and consumption decisions that keep the economy in balance. The current account deficit in the balance of payments represents, in macroeconomic terms, the savings investment gap in the economy.
The equilibrium interest rate is determined by market supply and demand, and it is the result of savings, investment and financing activities by market participants. If the Central Bank attempts to manipulate interest rates in order to stimulate growth, it will throw the credit system out of balance, which eventually leads to a crisis. If stability is desired, the variable that needs to be market-determined is the interest rate, not the exchange rate.
There is good reason why countries choose to maintain stable exchange rates, but the way to achieve this is not through interventions in the foreign exchange market but by allowing the interest rate to be market-determined. Ideally, Sri Lanka should adopt the exchange rate as the anchor for monetary policy, but if a completely fixed rate is not politically feasible, it should follow the lead of the majority of countries that limit the flexibility of the exchange rate in practice, within, for example, a 2.25% band. As an IMF paper (2020)[30] observes, “the exchange rate can be used as the main monetary policy instrument while the policy rate can target the exchange rate. An exchange rate anchor is compatible with an inflation objective”.
The benefit is that once the currency is pegged to the US dollar in the longer term, interest rates will converge to US rates (with an added risk premium, but this will still be low by Sri Lankan standards). The rate of inflation will also converge to US levels. With the right CBSL operating framework, this can be sustained. A sustainable low interest and low inflation environment, together with a stable currency, provide a solid foundation for economic activity.
If stabilization of output or employment is desired, then fiscal policy should be employed for this purpose.
Notes
[1] Mises, L. (1998). HUMAN ACTION A Treatise on Economics.
[2] Ibid
[3] American Numismatic Society. (2023). Paper Currency of the World.
[4] www.elibrary.imf.org. (n.d.). 2 Issues Concerning Nominal Anchors for Monetary Policy.
[5] Ibid
[6] Rockoff, Hugh (2015): War and inflation in the United States from the revolution to the first Iraq War, Working Paper, No. 2015-16, Rutgers University, Department of Economics,
New Brunswick, NJ
[7] Ibid
[8] Ibid
[9] Ibid
[10]Garber, P. (1991). National Bureau of Economic Research Volume Title: A Retrospective on the Bretton Woods System: Lessons for International Monetary Reform Chapter Title: The Collapse of the Bretton Woods Fixed Exchange Rate System.
[11] Ibid
[12]R Street Institute. (2024). Fifty Years Without Gold – R Street Institute.
[13]Rothbard(1963). What Has Government Done to Our Money? | Mises Institute.
[14]www.elibrary.imf.org. (1994). 2 Issues Concerning Nominal Anchors for Monetary Policy.
[15] See, for example, the argument by Irwin et al (2024) here: https://www.piie.com/blogs/realtime-economics/2024/fixation-fixed-exchange-rates-harms-developing-countries
[16] Calvo, G.A. and Reinhart, C.M. (2000). Fear of Floating.
[17] Rizvi, S.K.A., Naqvi, B., Mirza, N. and Bordes, C. (2017). Fear of floating in Asia and the credibility of true floaters. Research in International Business and Finance, 42, pp.149–160.
[18] Calvo, G.A. and Reinhart, C.M. (2002). Fear of Floating. The Quarterly Journal of Economics.
[19] Frankel, J. (2010). NBER WORKING PAPER SERIES MONETARY POLICY IN EMERGING MARKETS: A SURVEY.
[20] www.cvce.eu. (n.d.). The snake in trouble – Historical events in the European integration process (1945–2014) – CVCE Website.
[21] Ibid
[22] Gylfason, T. (1990). CHAPTER 4 Exchange Rate Policy, Inflation, and Unemployment: The Nordic EFTA Countries*.
[23] Rueff, J. (1972). The Monetary Sin of the West.
[24] Ibid
[25] Goodfiend, M. and King, R. (1988). FINANCIAL DEREGULATION, MONETARY POLICY, AND CENTRAL BANKING.
[26] Mishkin, F. (1998). Seminar Paper No. 648 INTERNATIONAL EXPERIENCES WITH DIFFERENT MONETARY POLICY REGIMES.
[27] Hausmann, R., 2016. Constraints to Sustained and Inclusive Growth in Sri Lanka, Growth Lab at Harvard’s Center for International Development.
[28] Reuters Staff (2012). IMF welcomes Sri Lanka’s move to a flexible exchange rate.
[29] Economy Two (2019). Sri Lanka to institutionalize ‘flexible exchange rate’ in new monetary law. [30] Khatat, M.E.H., Buessing-Loercks, M., Fleuriet, V. and Alwazir, J. (2020). Monetary Policy Under an Exchange Rate Anchor. IMF Working Papers, [online] 2020(180).