The stability of foreign exchange reserve level targeting for small open fixed exchange rate economies: Theory and an empirical examination of Germany, France, Italy and the United Kingdom

A monetary model of the open economy is used to fill in a gap in the assignment literature that neglects to take into account the limitations of the monetary and fiscal authority's ability to express policy. This limitation is that the monetary authority has only direct control over it holdings of domestic assets. The fiscal authority has direct control only over its own expenditures. With only these instruments, the stable assignments of instruments to targets are identified not only for the fixed exchange rate economy but for the dual exchange rate economies of the European Monetary System. The assignments of instruments to targets are then treated as policy reaction function and are empirically tested using data for the fixed exchange rate era and the period of the current EMS. The reaction function proved to be a powerful tool for the identification of policy and a useful perspective from which to analyze difficulties surrounding exchange rate instability and problems of growth.