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This is an important issue for policy-makers to take into account when considering whether or not, and to what degree, to apply monetary policy in an effort to contract or expand the supply of money. The sensitivity of international capital flows is an important factor in determining whether the money supply will react to an expansionary or contractionary monetary policy in the manner foreseen. If policy-makers perceive that an action will have a 100% impact on the economy and it ends up having only half that, many unexpected or unintended circumstances will arise. It is obvious that the implications of monetary policy and the resulting capital flows created would be of interest for someone involved in enacting policies affection the money supply in a country, particularly one with a fixed exchange rate.
In my paper I will first describe the economic structure of the problem of monetary policy and capital flows and show how the theory presented, specifically the theory hypothesized by Porter, is turned into the resulting econometric model. I will then go on to estimate and test the model while explaining both the results and the relevance of the tests. .
Model.
The basic economic issue that Porter addresses in his article is how monetary policy can induce capital flows, which may serve to reduce the magnitude of the policy. Specifically, when Australian policy-makers reduce the supply of money through open market sales of bonds an excess demand is created and domestic interest rates rise. When domestic interest rates rise compared to foreign interest rates, Porter uses Eurodollar rates, a flow of foreign exchange is created, which in turn adds to the reserves held by the banking system, which is an increase in the money supply. In the short run, as soon as the quarter following the policy action in Porter's findings, domestic monetary policy has caused an international flow of funds into the country that have offset the original action.
