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This study investigates the monetary effects under the floating exchange rates and imperfect capital mobility by extending the model of Bernanke and Blinder (1988) into a small open economy. It is shown that with credit channel of monetary transmission explicitly considered, the effect of monetary policy on output may be augmented or lessen in our model depending on whether the exchange rate depreciates or appreciates. In addition, the exchange rate puzzle found in the empirical studies can be explained in our theoretical model. The dynamic adjustment patterns of the output and the exchange rate after an increase in money supply are further examined. Under the case of relative high capital mobility, when the real output gradually adjusts toward a higher level, the exchange rate may overshoot, undershoot, or even counter-shoot during the dynamic adjustment process. This provides another one explanation for the volatility of exchange rates under floating rates. Therefore, as financial markets become more internationalized, the conduct of monetary policy turns more complicated in an open economy.

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