Even more on monetary policy in a small open economy

Abstract

It is well known that in a small open economy with full capital mobility and a fixed exchange rate, monetary policy is ineffective in influencing real output (e.g. the works of Fleming [Int. Monetary Fund Staff Pap. 9 (1962) 369.] and Mundell [Can. J. Econ. Polit. Sci. 29 (1963) 475.]). However, Wu [Int. Rev. Econ. Finance 8 (1999) 223.] finds that when the credit channel is added to this model, monetary policy can have real effects under a fixed exchange rate system. This conclusion hinges on the assumption that open market operations have no effect on foreign exchange reserves of the central bank when evaluating how a change in monetary policy affects the loan market. This assumption is incorrect because under a fixed exchange rate regime, the quantity of foreign reserves becomes endogenous in the model. It is shown that when this assumption is relaxed, monetary policy is still ineffective in influencing output under a fixed exchange regime, even with an operative credit channel.