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In an international financial framework, the effectiveness of monetary policy depends significantly on the type of exchange rate regime that an economy adopts. When analyzing two large economies, one operating under a fixed exchange rate system and the other under a flexible exchange rate system, the transmission, autonomy, and constraints of monetary policy become very different. These differences arise because of how exchange rates interact with domestic money supply, interest rates, and capital flows. In an economy with a fixed exchange rate system, the central bank commits to maintaining its currency at a predetermined parity against another currency or a basket of currencies. To sustain this parity, the central bank must intervene in the foreign exchange market by buying or selling foreign reserves. For instance, if there is upward pressure on the domestic currency, the central bank _____ _______ ________ ___ ____.
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