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It is well known that in a small open economy with full capital mobility and a fixed exchange rate, monetary policy is ineffective in influencing real output (e.g. the works of Fleming [Int. Monetary Fund Staff Pap. 9 (1962) 369.] and Mundell [Can. J. Econ. Polit. Sci. 29 (1963) 475.]). However, Wu [Int. Rev. Econ. Finance 8 (1999) 223.] finds that when the credit channel is added to this model, monetary policy can have real effects under a fixed exchange rate system. This conclusion hinges on the assumption that open market operations have no effect on foreign exchange reserves of the central bank when evaluating how a change in monetary policy affects the loan market. This assumption is incorrect because under a fixed exchange rate regime, the quantity of foreign reserves becomes endogenous in the model. It is shown that when this assumption is relaxed, monetary policy is still ineffective in influencing output under a fixed exchange regime, even with an operative credit channel.

A well-known implication of the Mundell–Fleming model (e.g. Fleming, 1962 and Mundell, 1963) is that monetary policy is ineffective in influencing real output under a fixed exchange rate regime. However, Wu (1999) finds that when the “credit channel” is added to the Mundell–Fleming model, monetary policy does have real effects.1 Thus, he argues that monetary policy is not completely endogenous under a fixed exchange rate, since the credit channel affects both the money market, as well as the goods market equilibrium. It is shown that Wu's (1999) conclusion hinges on the crucial assumption that open market operations have no effect on foreign exchange reserves of the central bank when evaluating how a change in monetary policy affects the loan market. Because of this assumption, Wu finds that the monetary base increases (decreases) with an open market purchase (sale), thereby affecting the bank loan supply schedule. However, this assumption is incorrect because under a fixed exchange rate regime, the quantity of foreign reserves becomes endogenous in the model. Once this assumption is removed, an expansion in monetary policy will not lead to the banking sector to generate more loans, rendering the credit channel ineffective, and, thus, restoring the result of monetary policy ineffectiveness under a fixed exchange rate regime. In Section 2, the essential equations of Wu's (1999) model were presented. To make the exposition as transparent as possible, the same notation was used and the same assumptions that Wu uses in his model were kept. In the Section 2.4, an intuitive explanation as to why monetary policy is ineffective even with an operative credit channel were offered.

Wu (1999) finds that augmenting the Mundell–Fleming model to include the credit channel changes the well-known result that monetary policy is ineffective in affecting real output in a small open economy with perfect capital mobility and a fixed exchange rate system. This note shows, however, that the conclusion is based on an erroneous assumption. Monetary policy cannot affect output if the country has a fixed exchange rate, even with an operative credit channel. In the standard Mundell–Fleming model, this happens because private investors undo what the central bank attempts to do with monetary policy. When the credit channel is added to the model, it is the banking system that undoes what the central bank tries to accomplish. In the end, however, the same conclusion remains. It is worth pointing out that while this paper shows that monetary policy has no real effects under a fixed exchange regime and operative credit channel, it does not follow that monetary policy is ineffective in stimulating output in every circumstance, even within the context of a fixed exchange rate regime. This result may be overturned in the context of the current model if, for example, policymakers imposed capital controls on the amount of foreign exchange domestic agents were allowed to obtain. In this case, the offset coefficient, dF/dBa, would be forced to be somewhere between −1 and 0, depending on the allowed degree of accessibility to foreign exchange reserves. This would result in monetary policy having real (albeit temporary) effects. Similarly, the monetary policy ineffectiveness result may be overturned if the assumption of a small open economy is relaxed. In this instance, the larger the country is relative to the rest of the world, the closer the outcome would be to the closed economy version of the model, which Bernanke and Blinder (1988) originally developed.