The question of Paul Volcker's reappointment generated controversy beyond anything in the history of the Federal Reserve Board. William McC. Martin was reappointed chairman a number of times with a minimum of fuss. Arthur Burns and William Miller arrived and departed without great debate. But suddenly the chairmanship had become President Reagan's most important appointment since he put Sandra Day O'Connor on the Supreme Court-- and that term is for life, not a mere four years.

One reason for this extraordinary rise in interest in the Fed is that the constant acrimony between the two ends of Pennsylvania Avenue on the subject of the budget has produced chaos in the form of unmanageable deficits, and the widespread view here and abroad that the United States merely has a fiscal result rather than any policy. This makes the Federal Reserve Board the only source of thoughtful macroeconomic planning in Washington. With the federal budget out of control, monetary policy is the only game in town, and the chairmanship of the Fed becomes correspondingly more critical to the future of the economy.

A more interesting but less widely understood reason for the increased importance of the Federal Reserve chairmanship is that the existence of a regime of flexible exchange rates during recent years has made monetary policy a far more powerful tool for the management of the economy then it was in the previous era of fixed exchange rates.

With flexible exchange rates, the adoption of a restrictive monetary policy, which raises interest rates and attracts foreign capital inflows, will cause an appreciation of the dollar. This increase in the exchange rate for the dollar makes imports cheaper n the United States and American products more expensive abroad. As domestic and foreign consumers respond to these shifts in relative prices, U.S. imports rise and exports fall, reducing aggregate demand and production in this economy.

The decline in the price of imports also forces U.S. firms that compete with imports to restrain their prices, and U.S. exporters are under strong pressure to reduce U.S. dollar prices to remain competitive abroad. Flexible exchange rates make monetary policy an awesome macroeconomic tool. Tight money produces an appreciation of the dollar that literally forces a reduction in a wide range of prices of traded goods, and sharply reduces aggregate demand through a decline in the trade balance.

If a fixed exchange rate for the dollar had been maintained, the effects of tight money would have been less impressive. Higher interest rates would have had restrictive impacts within the economy through their effects on investment expenditures, but the foreign capital inflows that resulted from higher yields would not have caused an appreciation of the dollar, which forced down prices and reduced production and employment in the export and import-competing sectors.

Instead, the U.S. balance of payments would have been pushed into surplus by the inflow of foreign funds, and this surplus would have increased the U.S. money surplus, partially cancelling the Fed's original tightening. Although this undesired increase in the money supply could be reversed through domestic monetary policy shifts, it remains true that a tightening of monetary policy would not directly affect the exchange rate, the domestic prices of traded goods or the trade balance. A fixed exchange rate makes monetary policy a far more limited tool for the management of the economy.

Flexible exchange rates have the additional effect of reducing the expansionary impacts of federal budget deficits and of thus weakening fiscal policy. An increase in government expenditures that raises federal borrowing and interest rates, for example, will attract foreign capital inflows and lead to an appreciation of the dollar. As the trade balance responds to the exchange rate, the expansionary effect of the government expenditure is largely offset by the loss of output in the export and import-competing sectors. The intended effects of the expansionary fiscal policy are "crowded out" through the exchange rate and the trade balance. In any conflict between an expansionary budget and a restrictive monetary policy, the central bank will win easily.

The success of the Federal Reserve System in dramatically reducing the U.S. rate of inflation during the last three years is largely the result of a 35 percent appreciation of the dollar during 1981 and 1982. This exchange rate change was also a major cause of the huge costs of this disinflation in terms of output and employment. The appreciation had particularly harsh impacts on export sectors such as agriculture and heavy machinery.

The recovery of these sectors depends on a depreciation of the dollar that has been expected for some time by many economists but that has not yet occurred.

Whether one supports or opposes the "cold shower" approach to fighting inflation of the last three years, it is clear that the great importance of Federal Reserve policy to the economy results in large part from the nature of the exchange rate regime. If the United States maintained a fixed exchange rate, the impacts of shifts in Fed policy would be far less dramatic, and there would probably have been far less interest in whether Paul Volcker was reappointed.