The problem I am studying is the relationship between monetary policy and capital flow. As with any macroeconomic issue, this is a complex topic which is influenced by many variables. Specifically, I will be looking at how domestic monetary policy, under fixed exchange rates, can create foreign capital flows that can counteract or partially counteract the intended monetary action of the central bank. The main source for the problem is an article published in The Economic Record in March of 1974 by M.G. Porter entitled, "The Interdependence of Monetary Policy and Capital Flows in Australia."" In Porter's study he concluded that 48% of any monetary policy action undertaken by the central bank of Australia was offset by foreign capital flows. .
In the particular case of Australia in the 60's and early 70's, the policy makers attempted to increase interest rates by contracting the money supply. They did succeed in controlling rates, but there actions had other consequences, as Porter states, "The question is not whether interest rates can be controlled but rather whether the sale of bonds required to enforce the policy is so great, and the induced increase in foreign reserves so substantial, that the policy fails because of the resulting disruption to the balance of payments."" The capital inflow brought about from such a policy can be large enough so that foreign reserves grow considerably introducing the possibility of speculative inflows. These inflows also bring with them an increased chance that the money supply will become unstable. Also, the rise in interest rates would add to any speculative pressure making the probability of a revaluation more likely. If people believe that a currency will be revalued, it's value rises vis -vis other currencies, they will buy up securities or convert their funds so that when the revaluation does occur, they will make a capital gain. The apparent cycle created by a policy such as this may have an adverse impact than the one intended by the central bank.
