Monetary Policy under Fixed Exchange Rates: Effectiveness, the Speed of Adjustment and Proper Use

Abstract

Some, though far from total, agreement has begun to emerge as to the role and effects of monetary policy in a closed economy. At least major issues have been delineated and the battle joined in terms of fairly well-defined analytical frameworks. The impact of changes in the stock of money (or its rate of change) on prices, output and interest rates has been discussed at the theoretical level and investigated empirically. Much dispute remains as to the lag-structure of response to monetary disturbances, as to the division into output and price effects, and as to proper monetary targets and policy indicators. Nevertheless, most economists would agree that monetary policy can be used as a countercyclical device, and that the stock of money (or its rate of growth) can, in some average sense over the medium run, be controlled, however difficult it may be to exercise such control in the very short run and however poorly monetary authorities have actually performed in this respect. Discussion of monetary policy in the open economy, on the other hand, has proceeded at a higher level of abstraction (or over-simplification) and empirical work has remained scarce. The reason is close at hand: with some notable exceptions, recent developments in monetary theory and policy analysis have been, largely, the work of economists based or trained in the United States; and, from an American vantage point (especially a Middle-Western one and before the so-called dollar crises), what more natural simplifying assumption than that of the closed economy? Yet, in recent years, under the pressure of events and following the rediscovery of Hume and Ricardo and the work of, among others, Meade, Alexander, Polak, Prais, Tsiang, Johnson and Mundell, the analysis of monetary policy in the open economy has made much progress, at least on a theoretical plane. The focus and conclusions of that work, especially that of Mundell, have been rather different from those of analyses dealing with the closed economy: the monetary balance-of-payments adjustment mechanism and the role of capital mobility and of the size of countries are emphasized; severe ' Preliminary versions of this paper were presented at the Second Konstanz Seminar on Monetary Theory and Policy (June, 1971) and at the February 1972 Money Study Group Conference held at Bournemouth. I am indebted to Leonall Anderson and Karl Brunner for their incisive discussion at Konstanz and to Harry G. Johnson for helpful comments. 136