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Short-Term International Capital Flows and the Effectiveness of Monetary Policy in an Open Economy: The German Case
Credit and Capital Markets – Kredit und Kapital, Vol. 11 (1978), Iss. 3 : pp. 365–378
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Rousslang, Donald J.
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Exchange rate expectations and speculative capital flows
Neumann, Manfred J. M.
Review of World Economics, Vol. 114 (1978), Iss. 3 P.552
https://doi.org/10.1007/BF02696467 [Citations: 0]
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Abstract
Short-Term International Capital Flows and the Effectiveness of Monetary Policy in an Open Economy: The German Case
This paper develops a model to determine the ability of the monetary authorities of an open economy to exercise discretionary control over the domestic monetary base under a system of fixed exchange rates. A reduced form equation is derived from the model and is used to estimate directly the effects on capital flows of policy actions which consist of changes in the domestic reserve base. The model uses the assumption that, in a period of short-run financial market equilibrium, a change in domestic excess demand for credit, caused by a change in bank reserves, results in capital flows as domestic residents make substitutions between foreign and domestic financial assets or liabilities in their bond portfolios. These adjustments of domestic bond portfolios are assumed to occur before adjustments among bonds, money and commodities. The model is applied to the German economy for the period from November 1962 through May 1971 after which Germany adopted a floating exchange rate. Monthly data are used in the empirical application of the model. Since an important tool of German monetary policy, changes in reserve requirements, are instituted only on the first day of the month, the use of monthly data helps resolve the problem of simultaneous-equations bias between policy-induced changes in the monetary base and the resulting short-term capital flows. Monthly data also provides better evidence than quarterly data as regards the direction of causality between capital flows and policy-induced changes in the monetary base. The empirical results of this paper indicate that the reactions of short-term international flows to policy-induced changes in the monetary base are substantially completed within the month, and that such capital fiows react to offset at most 57 to 59 percent of policy-induced changes in the monetary base. Since the offset ist not complete, short-term international capital flows did not prevent the German monetary authorities from pursuing an independent monetary policy under a system of fixed exchange rates, though it is possible that occasional exchange rate parity adjustments were necessary if this independence was to be maintained when there were widespread expectations of a shift in parity.