Monetary policy and the determination of the interest rate and exchange rate in a small open economy with increasing capital mobility

This paper presents a general model of the determination of the interest rate and the exchange rate which is relevant for a small economy with any degree of capital mobility. The model is tested by using the quarterly data of Korea and Singapore. The emperical results show that in the Korean case changes in money supply affect the interest rate, but do not affect the exchange rate, while in the case of Singapore the domestic interest rate is determined by the foreign interest rate and the expected change in the exchange rate, as well as by changes in the money supply; changes in the money supply also influence the exchange rate. The results imply that the progress of capital liberalization in a small country will alter the transmission mechanism from reliance on the interest rate channel alone to effects arising through both the interest rate and the exchange rate.