On the effectiveness of monetary policy under fixed rates of exchange

The IS-LM framework traditionally used to discuss the role of monetary policy under fixed rates of exchange has several weaknesses. The theoretical findings based on such a model cannot be accepted uncritically. The paper reassesses the role of monetary policy by appropriately modifying the IS-LM apparatus so that its resilts can be easier to compare with much of the existing literature. The meaning and effectiveness of monetary policy is analysed in short-run equilibrium, stock-flow equilibrium and full long-run equilibrium. Dynamical equations linking the short to the long run are specified. The notable implication is that monetary policy is effective in the short run and need not be ineffective in the long run. Complete emasculation of monetary policy occurs when the central authorities relinquish control over the flow distribution of government debt between money and bonds in favour of an independent use of a set of fiscal instruments. Perfect capital mobility requires that the central authorities decide whether monetary or fiscal policy become totally dependent on external forces. Whether one or the other is chosen is more a matter of specific circumstances than theoretical necessity. Critical comments are directed at the literature on offsetting capital flows.