What are the most effective exchange rate policies in stabilizing the economy?

The stability of exchange policies has become complicated by external forces. Even if a country can manage prudent fiscal or monetary policies it is still effected by global liquidity unless it is G-7 country. Global liquidity is a function of large central banks balance sheets and if they try to expand their B/S then Gush of liquidity flows into asset distorting the exchange rates. On the other hand any tightening of global liquidity could lead to countries having to sacrifice their own economic growth and prioritize the stability of exchange rates.

Maintain an Exchange Rate policy that attracts foreign investors from affluent economies that possess plenty of capital & other resources and excess capital to invest abroad. Attract only those with an impeccable track record

Fixed interest rates can create several problems for a country's economy. Firstly, they make it hard for the government to adjust its monetary policy to suit the country's specific needs, which can lead to economic imbalances. Also, fixed rates can attract unpredictable and risky investment, which might seem good at first but can quickly become unstable, shaking up the financial system. Countries using fixed rates are more exposed to sudden changes in the global economy and need a lot of foreign cash reserves to manage these risks. This requirement limits how much the government can do to boost the economy or help people during tough economic times.

A floating exchange rate system is generally seen as more rational for an economy because it depends on market forces. This flexibility allows the currency to adjust and stabilize in response to economic changes, including variations in interest rates, inflation, and trade balances. Consequently, the economy is better equipped to handle external shocks. Such autonomy in monetary policy is essential for tackling domestic economic issues. Moreover, floating rates help deter speculative attacks on the currency, reducing the likelihood of investors speculating against a currency that adjusts on its own.

A managed exchange rate policy, blending fixed and floating rate benefits, faces significant challenges. Determining when & how much to intervene is complex, risking currency misalignment with market fundamentals. Such misalignment can hurt exports or cause inflation. Balancing exchange rate stability with other economic goals like inflation control is challenging, often leading to conflicting policy outcomes. Implementing this policy demands substantial resources and effective communication, which is difficult to maintain. Additionally, frequent interventions can hinder the development of a fully efficient foreign exchange market and might attract international criticism, especially if seen as unfair trade practices.

What is the optimal exchange rate policy? Should exchange rates be optimally pegged, managed, or allowed to freely float? Do open economies face a trilemma constraint in choosing between inflation and exchange rate stabilization, unlike the divine coincidence in a closed economy? These are generally difficult questions, as the exchange rate is neither a policy instrument nor a direct objective of the policy. Let's give an example from Turkiye. After the collapse of the fixed exchange rate regime in 1980, alternative regimes were adopted in Turkey. The “crawling peg” regime (1980-81) is followed by “managed float” (1981-99), “crawling peg” (1999-2001) and “free-floating” (2001-) in “de jure” classification.

Optimal exchange rate policies hinge on an economy's specifics: size, openness, and the nature of shocks it faces. Smaller economies might favor fixed rates for stability, while larger ones could opt for floating rates for flexibility. Central banks must align exchange rate strategies with their goals, such as inflation control or growth stimulation. Adapting policies, from fixed to more flexible systems like currency corridors, allows for responsiveness to economic shifts and long-term objectives, ensuring that exchange rate management remains a key tool in economic stabilization and growth.

The exchange rate is influenced not only by the actions of the central bank but also by the government of the country. Often, their actions are diametrically opposed in terms of their impact on the national currency exchange rate. For instance, while the central bank may try to control inflation through a strict monetary policy, the government actively stimulates infrastructure projects, defense spending, or social policies by increasing the budget deficit. Consequently, the central bank's ability to stabilize the exchange rate is significantly diminished. Therefore, a floating exchange rate seems to be a more rational choice than a fixed one, as the former is more adaptable to changing macroeconomic conditions.