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The Effectiveness of Monetary Policy Reconsidered

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  • John Weeks

Abstract

In this PERI Working Paper, John Weeks inspects the standard policy rule that under a flexible exchange rate regime with perfectly elastic capital flows, monetary policy is effective, and fiscal policy is not. The logical validity of the statement requires that the effect of an exchange rate change on the domestic price level be ignored. The price level effect is noted in some textbooks, but not formally analyzed. When it is subjected to a rigorous analysis, the interaction between changes in the exchange rate and the domestic price level significantly alters the standard policy rule. According to Weeks, the more accurate statement would be: under a flexible exchange rate regime with perfectly elastic capital flows the effectiveness of monetary policy depends on the values of the import share and the sum of the trade elasticities. Inspection of data from developing countries indicates the effectiveness of monetary policy under flexible exchange rates can be quite low, even if capital flows are perfectly elastic.

Suggested Citation

  • John Weeks, 2009. "The Effectiveness of Monetary Policy Reconsidered," Working Papers wp202, Political Economy Research Institute, University of Massachusetts at Amherst.
    • Handle: RePEc:uma:periwp:wp202
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    File URL: https://per.umass.edu/fileadmin/pdf/working_papers/working_papers_201-250/WP202.pdf
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    References listed on IDEAS

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