The Independence of Monetary Policy

One of the major analytical and practical issues in the analysis of the open economy is the extent to which governments are able to pursue independent monetary policies. As noted in earlier chapters, one strand of the theoretical literature establishes that a key difference between fixed and floating exchange-rate systems is the degree of monetary independence afforded to governments. The broad conclusions of this theoretical analysis are that when the exchange rate is fixed the domestic monetary counterpart of foreign-exchange market intervention effectively means that the monetary authorities lose control over the domestic money supply. On the other hand, the domestic money supply is largely insulated from external developments with a floating exchange rate.