Money Supply, Interest Rate and Exchange Rate Targets: Conflicting Issues in an Open Economy

Abstract

Monetary strategies are one of the factors determining the process of shock absorption in the economy. The problem consists in organising the ‘shock absorbing capacity’ (Parkin, 1978) of the economy so that certain targets such as, for example, the stabilisation of output or the price level can be reached in an optimal way. From a monetary policy view point, this implies mainly to decide to what extent shocks should be contained by varying the money supply, interest rate or exchange rate of the economy. Recently, various articles examining this problem have been published. In a Poole-type model framework (see Poole (1970)), the conditions for an optimal monetary strategy in an open economy are discussed (see, for example, Parkin (1978), Fortin (1979), Sparks (1978), Melitz (1983), and Aizenman and Frenkel (1985)) and special criteria for an optimal exchange rate flexibility are derived (see, for example, Boyer (1978), Helpman and Razin (1979), Roper and Turnovsky (1980), Frenkel and Aizenman (1983), Melvin (1985) and Pohl (1985)). These articles either examine the effects of different monetary strategies (stabilising money supply, interest rate or exchange rate) on output variance, or they develop optimal combinations of money supply, interest and exchange rate movements on the basis of a monetary policy reaction function.