Money supply transmission between major trading partner countries in a simple test of monetary autonomy

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Virginia Polytechnic Institute and State University


One of the most important conclusions derived from the monetary approach to the balance of payments concerns the inability of a country operating under a fixed exchange rate regime to maintain an autonomous internal monetary policy at variance with that of the rest of the world.

In the approach taken here, the domination of a small country by the monetary policy of a large trading partner (representing the world, i.e. with an economy likely to be unaffected by any action of its small partner yet strongly influencing that country's income) is examined for thirty-six country pairs. Transmission was measured by evaluating a linear autoregressive ordinary least squares model which identified the relationship, if any, of current changes in the rate of growth of money in the small country to past changes in money growth rates in the larger country. The monetary approach is strongly confirmed in the fifteen country pairs showing the longest periods of fixed currency values between the two. In addition, for those instances in which the monetary policy of the small country showed no relationship to that of the larger country, conditions that would potentially validate the monetary model were identified.