Recent years have seen considerable debate on the effectiveness of monetary policy under fixed exchange rates. Much of this literature argues that monetary policy under fixed exchange rates is completely ineffective in influencing national income or the rate of interest. Indeed there has been a proliferation of macroeconomic models, particularly ones developed by those economists who follow the monetary approach to the balance of payments, which assume that the rate of interest and national income is not affected by monetary policy actions. This thesis re-examines the issues in this debate.
The fundamental question is the extent to which expansionary or contractionary policy is offset by capital flows. The specification of the capital flow equation used in macroeconomic models is thus of considerable importance and the next two chapters develop the specification used in the remainder of the thesis. Chapter 2, by drawing on the theory of portfolio selection under uncertainty derives, the stock demand for internationally traded assets in a two country, three asset model. Chapter 3 then uses this theory to develop a portfolio or stock adjustment approach to capital flows. In this approach capital flows are seen as the means by which portfolio holders attain their desired allocation of assets across international boundaries. These chapters provide the microfoundations for the capital flow equation.
Although this stock adjustment approach has been used in a number of empirical studies, the implications of this approach for the effectiveness of monetary policy do not appear to have been fully drawn out in the literature. Chapter 4 incorporates the stock adjustment approach to capital flows in a Keynesian model of an open economy. It is argued that aspects of the traditional theory must be reformulated if capital flows are appropriately considered as a stock adjustment process. A number of conclusions follow from the stock adjustment approach to capital flows which are at odds with the received doctrine on the effectiveness of monetary-policy.
Chapter 5 abandons the Keynesian framework and considers the monetary approach to the balance of payments. This theory applies the tenets of monetarism to an open economy and represents one of the major schools of thought to argue that monetary policy is ineffective in open economies. In Chapter 6, a simple empirical model of the Australian economy is used to resolve the empirical issues which have been raised in previous chapters. The final chapter summarizes the findings of the theoretical and empirical work.