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The Effectiveness of Monetary Policy Reconsidered

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  • John Weeks

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    (Professor Emeritus, School of Oriental and African Studies, University of London)

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    Abstract

    This paper 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 domestic price level effect of devaluation be ignored. The price level effect is noted in some textbooks, but not analysed. When it is subjected to a rigorous analysis, the interaction between exchange rate changes and domestic price level changes render the standard statement false. The logically correct 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. Monetary policy will be more effective than fiscal policy if and only if the sum of the trade elasticities exceeds the import share. Inspection of data from developing countries indicates a low effectiveness of monetary policy under flexible exchange rates. In the more general case of less than perfectly elastic capital flows, the conditions for monetary policy to be more effective than fiscal policy are even more restrictive. Use of empirical evidence on trade shares and interest rate differentials suggest that for most countries fiscal policy would prove more effective than monetary policy under a flexible exchange rate regime. In any case, the general theoretical assertion that monetary policy is more effective is incorrect. The results sustain the standard Keynesian conclusion that fiscal policy is more effective, whether the exchange rate is fixed or flexible. (...)

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    File URL: http://www.ipc-undp.org/pub/IPCTechnicalPaper3.pdf
    File Function: First version, 2008
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    Bibliographic Info

    Paper provided by International Policy Centre for Inclusive Growth in its series Publications with number 3.

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    Length: 15
    Date of creation: Jun 2008
    Date of revision:
    Publication status: Published by UNDP - International Poverty Centre, June 2008, pages 1-15
    Handle: RePEc:ipc:pubipc:1616109

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    Keywords: The Effectiveness of Monetary Policy Reconsidered;

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    Cited by:
    1. nnamdi, Kelechi & ifionu, Ebele, 2013. "Exchange rate volatility and exchange rate uncertainty in Nigeria: a financial econometric analysis (1970- 2012)," MPRA Paper 48316, University Library of Munich, Germany, revised 2013.

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