This paper studies the interaction of international capital flows, monetary policy and interest rate adjustment in an open economy. Monetary independence is often measured by the so-called offset coefficient, defined as the induced change in foreign exchange reserves of the central bank as a response to a domestic open-market operation. However, Fratianni (1977) demonstrates that the actual value of the offset coefficient may be less useful for the assessment of the scope of monetary autonomy of a srmall open economy than the existing literature suggests.1 His discussion seems to imply that the magnitude of the effect that open-market operations have on the domestic market rate of interest is more relevant than the value of the offset coefficient for the evaluation of monetary independence.2 In this paper we re-examine the above issues. The following arguments will be put forward. First, for the evaluation of monetary independence it is useful to study the effects of domestic monetary policies both on the rate of interest and the capital account of the balance of payments.3 Second, the offset coefficient is less useful for the assessment of the scope of monetary autonomy than suggested by the standard reduced-form models, which regress the net capital flows on domestic credit.4 This is because the portfolio balance approach that is used to derive this model neglects both the flow nature of capital flows and the implications of monetary policy reaction function. In fact, as first suggested by Herring and Marston (1977), the offset coefficient may be more sensitive to the parameters of the monetary policy rule than to private capital flows. The above issues will be discussed in a modified asset market model which allows for slow adjustment of the stocks of financial assets in private portfolios and which integrates the policy rule into the model. This model emphasizes the interest rate mechanism more than the model with continuous portfolio balance since it implies interest rate overshooting in the short run relative to the long run. Moreover, different values for the offset coefficient are obtained for the short run and for the long run. It is well-known that if the authorities, faced with internal targets, try systematically to sterilize the effects of balance of payments disequilibria on the domestic money supply, this will have a very significant influence on reserve volatility through capital flows (see Argy and Kouri, 1974). This is neglected, however, in the reduced-form models of capital flows. More recently, Obstfeld (1980, 1982) has dealt with the simultaneous equation bias in single-equation econometric studies of the capital account offset to monetary policy. The structural form approach favoured by him and his results of the effects of the sterilization rule support the propositions of this paper.5 But it seems that the