Suppose U.S. inflation is 8 percent, but it is only 5 percent in the rest of the world, due to differing money-supply growth rates. With a fixed exchange rate, during the first year U.S. prices rise by 3 percent more than foreign prices. If nothing changes, during the following year the gap between U.S. and foreign prices widens by another 3 percent, and so on, year after year. It is not true, however, that nothing changes.

Prices in the United States are rising relative to foreign prices, so U.S. exports should fall and imports should rise. As a result, the United States should develop a balance of payments deficit, and the rest of the world should develop a balance of payments surplus. Under fixed exchange rates these developments should automatically decrease the U.S. money supply and automatically increase the foreign money supply. The fall in money-supply growth in the United States lowers its rate of inflation over the long run, and the increase in money-supply growth in the rest of the world increases foreign inflation over the long run. The pressure on both inflation rates continues as long as the U.S. inflation rate exceeds that of the rest of the world. Eventually, inflation and money-supply growth in the rest of the world should match those of the United States.

Does inflation in the rest of the world rise to match American inflation? Does American inflation fall to match foreign inflation? Or do they both move to an intermediate rate? From 1945 to 1971 when most countries were on a fixed exchange rate system, the Bretton Woods system, all countries fixed their exchange rates relative to the U.S. dollar so that in essence everything was measured in U.S. dollars. As a result, the United States could simply print U.S. dollars to cover its balance of payments deficit, eliminating any automatic contraction of the money supply. Consequently, the rest of the world was forced to experience U.S. monetary policy and inflation rate.

The bottom line here is that under a fixed exchange rate, a small, open economy loses control of its monetary policy, which is forced to be identical to that of the larger country to whose currency its exchange rate is fixed. Note that this analysis corroborates the result of the preceding chapter: monetary policy is ineffective under a fixed exchange rate.