According to the well-known trilemma,government can choose only two out of the following three: independent domestic policy (usually described as an interest rate peg), fixed exchange rate, and free capital flows. A country that floats its exchange rate can enjoy domestic policy independence and free capital flows. A country that pegs its exchange rate must choose to regulate capital flows or must abandon domestic policy independence. If a country wants to be able to use domestic policy to achieve full employment (through, for example, interest rate policy and by running budget deficits), and if this results in a current account deficit, then itmust either control capital flows or it must drop its exchange rate peg.Floating the exchange rate thus gives more policy space. Capital controls offer an alternative method of protecting an exchange rate while pursuing domestic policy independence.Obviously,such policies must be left up to the political process—but policy-makers should recognize accounting identities and trilemmas. Most countries will not be able to simultaneously pursue domestic full employment, a fixed exchange rate, and free capital flows. The exception is a country that maintains a sustained current account surplus—such as several Asian nations. Because they have a steady inflow of foreign currency reserves, they are able to maintain an exchange rate peg even while pursuing domestic policy independence and (if they desire) free capital flows.
Look at Cyprus!
Just in case that wasn’t clear enough, lifted from the same place:
Let us quickly review the connection between choice of exchange rate regime and the degree of domestic policy independence accorded, from most to least:*Floating rate, sovereign currency most policy space; government can “afford” anything for sale in its own currency. No default risk in its own currency. Inflation and currency depreciation are possible outcomes if government spends too much.*Managed float, sovereigncurrency less policy space; government can “afford” anything for sale in its own currency, but must be wary of effects on its exchange rate since policy could generate pressure that would move the currency outside the desired exchange rate range.*Pegged exchange rate, sovereign currency least policy space of these options; government can “afford” anything for sale in its own currency, but must maintain sufficient foreign currency reserves to maintain its peg. Depending on the circumstances, this can severely constrain domestic policy space. Loss of reserves can lead to an outright default on its commitment to convert at the fixed exchange rate.
Even here in Australia, regardless which side is in Government, we act like we’re on one of the latter two and we have not been since 1983.