Transmission of monetary policy in an open economy : a theoretical model applicable to Finland

Abstract

A high degree of international capital mobility considerably reduces the effectiveness of monetary policy in small open economies under the system of fixed exchange rates. The extent to which monetary policy actions are offset by capital flow s, has been a subject of much recent theoretical and empirical research. In this study the relationship between capital mobility and the money supply process is analyzed in .the context of an economy with underdeveloped financial markets and extensive interest rate regulation. A theoretical model of the money supply process is developed with special attention paid on the behavior of the banking system under the special circumstances. A hypothesis of the transmission mechanism is developed, according to which monetary policy first affects the real sector by changing credit availability and the asset price level of real cap ital. The effects of capital flows on the transmission mechanism are assessed. Potency of monetary policy is greatly reduced by capital movements, but whether a policy can be completely offset, depends on the kind of policy used. A change in the net monetary base cannot be completely offset by capital flow s, whereas policies affecting the net base multiplier, e.g., discount rate and reserve requirement changes, can be rendered ineffective by capital movements.