Identifying Monetary Policy Under Fixed Exchange Rates in a Small Open Economy

Abstract

Purpose: This paper is an empirical investigation of the transmission of monetary policy in a small open economy with fixed exchange rates. The paper argues that under a fixed exchange rate system and free mobility of capital, the ability of monetary policy actions to affect the real variables of the economy is limited and constrained by maintaining the peg. Theoretical framework: The study's theoretical framework examines how Jordan's monetary policy, influenced by a fixed exchange rate with the U.S. dollar, responds to domestic and external shocks, with an emphasis on the transmission of these shocks through key economic variables. Design/Methodology/Approach: A two-country structural macroeconomic model has been developed to describe the small economy that explicitly incorporates an interest rate differential. Findings: Using Jordan as a case study during the period when its currency was pegged to the U.S. dollar, vector auto-regression analysis reveals that there is evidence of a strong U.S. monetary policy influence on the Jordanian economy. The results show that adjustment of the policy rate by the central bank of Jordan in response to Federal Reserve actions has no significant impact on output while the interest rate differentials tend to have an immediate influence on inflation with short lags, albeit small in magnitude. Research, Practical & Social implications: The research provides insights that can inform effective monetary policy strategies in small open economies like Jordan, offering implications for policymakers and contributing to economic stability. Originality/Value: The originality of this study lies in its comprehensive analysis of Jordan's monetary policy within the context of a small open economy, offering valuable insights into the effects of external shocks, exchange rate regimes, and policy responses on key economic variables.