Influence of Exchange Rate regime on Effectiveness of Monetary Policy Essay

Influence of Exchange Rate regime on Effectiveness of Monetary Policy - Essay Example According to Cespedes, Chang & Velasco (2002, p. 1), â€Å"this kind of a model treats the financial markets and international capital mobility as perfect.† Therefore, by using this model to explain the effectiveness of a monetary policy, we would be making an assumption that capital mobility and financial markets are perfect. A country can apply either a fixed exchange rate regime or a flexible exchange rate regime in its monetary system. These two regimes differ both in their characteristics and in applicability. Unlike a flexible regime, a fixed regime has an automatic monetary policy response that the monetary institution has little influence on (Klein & Shambaugh 2010). However, they both define how the currency of a country exchanges with currencies of other countries. According to IMF (1988), exchange rates influence capital flow in and out of the country. Therefore, since the exchange rate regime adapted would influence the exchange rates then it would influence the ca pital flow in and out of the country. A monetary policy affects the money market of a country. This type of policy is crucial in finding a solution to economic problems. Its basis is the supply of money rather than the terms and rates of trade (Jain & Khanna 2007). Therefore, the monetary institutions design this kind of a policy to control either the amount of currency in circulation or the cost of a currency relative to currencies of other nations. However, in controlling the amount of currency in circulation and cost of a currency, the policy should control the terms and rate of a trade in a country. That is now where the issue of the effectiveness of a policy comes from. An effective monetary policy is one that has the capacity to control terms and rates of trade thus controlling the economy of the country. The three lines in the IS-LM BP model are the open IS curve, the open LM curve and the BP curve (Chamberlin & Yueh 2006). Although we use the word ‘curve’ to men tion them, in a diagram they are represented as straight lines. We can use this kind of a model for different purposes one of them being the analysis of a policy. When we use this model to analyze a policy, each of these curves would represent a different aspect of the policy that can identify its effectiveness. In this case, what we would be interested in is the intersection point of the lines in the model. Below is an illustration of this type of a model retrieved from the internet. Diagram of the IS-LM BP model (Deardorff 2010, p. 1) Each line in the diagram above is a representation of an aspect of a monetary policy that we aim to analyze. We can observe from the diagram that all the three curves intersect at one point called the equilibrium point. We can use these lines to explain how a monetary policy affects the economic activities of a country and thus draw a conclusion of its effectiveness. According to Furstenberg (1984), international exchange of national money and moneta ry equilibrium are the main causes of the effectiveness of monetary policy. We could use the IS-LM BP model to represent and interpret these aspects of the monetary policy. The intersection of all the curves in the model represent the monetary equilibrium while each of the curves represent an aspect of international exchange of national money. The nature of the curves, its shifts, and their point of intersection depend on the