International Monetary Policy - Term Paper Example

Traditionally monetary policy was used by setting money supply and credit supply to attain the desired level of inflation in the country. In the short run, monetary policy had the objective to maintain price stability. Under that regime higher employment and sustainable economic growth were regarded through low inflation as one of the theoretical frameworks of monetary policy (Solow & Taylor, 1998). The effects of money supply decisions are transmitted through the interest rate channel through the economy. The transmission mechanism in the economy is not as simple as it seems since there are uncertainties about timings, expectations, exchange rate, interest rate, and balance of payments (Canada, 1999). This traditional framework of monetary policy has been effective for the domestic and closed economies but with the changing scenarios of economic integration and interdependence.

This emergence of new economic activities across borders gave birth to a new dimension of monetary policy which was named International Monetary Policy. International monetary policy analyses the effects of policy decisions on the international finances of a country through exchange rates (Odell, 1982). Monetary policy only overlooks the domestic aspect of interest rate while in international monetary policy the focus is more on the balance of payments and the balance of trade. The policy decision of money supply leads to appreciation/ depreciation of currency while other factors remain the same due to which the exchange rate may overshoot instantly.

Considering such complications and impediments, international monetary policy can serve the purpose to achieve targets through either stabilizing the exchange rate or fixed exchange rate or currency unions, or through dollarization (Scammell, 1975). So, traditional monetary policy doctrine failed to capture the independent nature of the monetary policy. The regime of International monetary policy was first acknowledged around four decades ago which recognized the international monetary policy spillover and helped in reconsidering and reshaping the macroeconomic and open economy monetary models.