1. Let me elaborate on the last post regarding exchange-rate regimes:
(i) There are different types of exchange-rate regimes, of which the fixed-exchange rate and the floating-rate are but two of the extreme or the pure. There is potentially an infinite number of regimes between those two, depending on the objective of the central bank. The solution on choice of regime is indeterminate.
(ii) Each of the infinite number of regimes, including the two pure ones, are complete equilbrium models by themselves - meaning, which ever regime is chosen, there are consequences on the fundamentals of the economy. Forces will be at play and, one way or another, the economy will adjust.
(iii) I had taken pains to elaborate on how such adjustments did actually take place in 1997/98 in an earlier post on 23rd June. The central bank may control one or two variables, but the rest of the economy will have to make all the adjustments - sometimes without choice, as the 1997/78 case showed us.
(iv) The most glaring consequences of the current regime are the inflationary forces in the local economy (as probably in other parts of the world). The external surplus gives huge liquidity to the corporate sector and the banking sector which together drive their profits not only through volume increase but mostly through the management of inflationary expectations - such as property prices will always go up. The second impact is through the higher global commodity prices and higher imported prices.
(v) It is easier to strengthen the currency in an external surplus situation (because the central bank can print less money to buy the foreign reserves) rather than trying to defend the currency in an external deficit situation (because the central bank may not have enough foreign currencies to buy back its own currency from the market).
2. Let's introduce the interest rate.
(i) Technically, the interest rate influences short-term capital flows. If the local deposit rate is higher than foreign deposit rate (which it is currently not), short-term capital will flow in. If the local deposit rate is lower than the foreign deposit rate (which it is not, except with respect to Australia and New Zealand), short-term capital will flow out. It is probably for the reason of keeping short-term capital flows at bay that the policy is to keep local deposit rates very closely to foreign interest rates. At the moment, zero interest rates are a global fashion.
(ii) As an aside, though the local deposit rates may take a neutral stance on short-term capital flows, capital especially of private individuals and corporates may still move for other reasons. The lack of investment and business opportunities. The loss of confidence. There is no money to be made for taking risk.
(iii) The interest rate of course has an impact on business profitability. But to lower deposit rates even to zero may not be sufficient to revive the economy for various reasons. The deposit rates may be zero but the lending rates may be unchanged. There is a transfer of income from depositors to banks. Banks may be fearful to lend without collateralising on real estate because of rising bad and doubtful debts in their books. Banks may have no view on where the economy is going.
(iv) Some investors (rather speculators) try to gauge local investment conditions from the real interest rate. Lending interest rate (5%) minus inflation rate (3%) equals real interest rate (+2%). There is no scope for arbitrage: borrowing from banks to pay back through inflation. You can see from here the strong urge to fan the flames of inflation so that there is money to be made by the girls and boys in suits at the expense of the general public's real purchasing power.