Exchange Rates and Monetary Policy in Emerging Market Economies

Devereux, Michael B.; Lane, Philip R.; Xu, Juanyi

doi:10.2139/ssrn.739024

Cited by 135 publications

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“…22 22 CPI inflation targeting is a realistic description of the conduct of Korean monetary policy following the abandonment of the fixed exchange rate (see Bank of Korea 2003 for details). Moreover, as shown by Devereux, Lane, and Xu (2004), CPI inflation targeting is the best monetary policy rule in an environment of low exchange rate pass‐through. …”

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confidence: 99%

External Constraints on Monetary Policy and the Financial Accelerator

Gertler¹,

Gilchrist²,

Natalucci³

2007

J of Money Credit Banking

350

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We develop a small open economy macroeconomic model where financial conditions influence aggregate behavior. We use this model to explore the connection between the exchange rate regime and financial distress. We show that fixed exchange rates exacerbate financial crises by tieing the hands of the monetary authorities. We then investigate the quantitative significance by first calibrating the model to Korean data and then showing that it does a reasonably good job of matching the Korean experience during its recent financial crisis. In particular, the model accounts well for the sharp increase in lending rates and the large drop in output, investment and productivity during the 1997-1998 episode. We then perform some counterfactual exercises to illustrate the quantitative significance of fixed versus floating rates both for macroeconomic performance and for welfare. Overall, these exercises imply that welfare losses following a financial crisis are significantly larger under fixed exchange rates relative to flexible exchange rates.JEL Classification: E5, F3, F4

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confidence: 99%

External Constraints on Monetary Policy and the Financial Accelerator

Gertler¹,

Gilchrist²,

Natalucci³

2007

J of Money Credit Banking

350

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“…The investment adjustment cost parameter ψ I is set to 12.44 so that the elasticity of Tobin's Q with respect to the investment-capital ratio is 0.3, and the portfolio adjustment cost parameter ψ D is set to 0.0007 (Devereux et al 2006). The investment adjustment cost parameter ψ I is set to 12.44 so that the elasticity of Tobin's Q with respect to the investment-capital ratio is 0.3, and the portfolio adjustment cost parameter ψ D is set to 0.0007 (Devereux et al 2006).…”

Section: àmentioning

confidence: 99%

“…This is because in the face of sticky prices of nontraded and imported goods, the monetary authority must stabilize real exchange rates to stabilize the CPI inflation, which requires an increase in domestic interest rates to prevent an immediate large depreciation of real exchange rates (Devereux et al 2006;Smets and Wouters 2002). This is because in the face of sticky prices of nontraded and imported goods, the monetary authority must stabilize real exchange rates to stabilize the CPI inflation, which requires an increase in domestic interest rates to prevent an immediate large depreciation of real exchange rates (Devereux et al 2006;Smets and Wouters 2002).…”

Section: Effect Of External Shocks Under Alternative Fiscal-monetary mentioning

confidence: 99%

“…1 The model shares three features with the existing literature (for example, Devereux et al 2006;Smets and Wouters 2002): (1) monopolistic competition in the nontraded and imported goods markets, (2) price rigidities for nontraded goods, and (3) incomplete exchange rate pass-through. 1 The model shares three features with the existing literature (for example, Devereux et al 2006;Smets and Wouters 2002): (1) monopolistic competition in the nontraded and imported goods markets, (2) price rigidities for nontraded goods, and (3) incomplete exchange rate pass-through.…”

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The Fiscal-Monetary Policy Mix and Exchange Rate Stability: A Dynamic Stochastic General Equilibrium Model With Chinese Characteristics

Jia

Guo

Wang

2015

Emerging Markets Finance and Trade

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We develop a small open economy model and compare alternative fiscal-monetary policy mixes using data for China. We show that the trade-offs faced by policy makers involve not only the stabilization of output, inflation, and real exchange rates, but also government debt stability. The source of shocks has important implications for the trade-offs. In the face of external shocks to interest rates or inflation, a passive fiscal and active monetary policy mix performs well in stabilizing government liabilities, inflation, and real exchange rates but generates higher output volatility. An active fiscal and active monetary policy mix is much more stabilizing in response to internal shocks to government expenditures or sector-specific productivity.KEY WORDS: fiscal policy, fiscal-monetary policy mix, real exchange rates, government debts, two-sector small open economy model, ChinaSince the financial crisis in the late 1990s, how to design macroeconomic policies to stabilize exchange rates, especially for emerging market economies, has increasingly drawn attention from policy makers and academia. Using a dynamic stochastic general equilibrium (DSGE) model, Smets and Wouters (2002) analyze optimal monetary policy in an open economy with incomplete exchange rate pass-through. Devereux et al. (2006) study the effects of incomplete exchange rate pass-through and external borrowing constraints on the conduct of monetary policy for an emerging market economy. De Paoli (2009) analyzes optimal monetary policy using a small open economy model with a special focus on whether the exchange rate stability should be part of monetary policy strategy. Recently, Lombardo and Ravenna (2014) explore the effect of the trade composition on optimal monetary policy and optimal volatility of the exchange rate. Chang et al. (2014) identify the importance of the cost channel of monetary policy in a small open economy with financial frictions.However, most of these studies have been conducted in the context of highly stylized economic and policy environments. They typically examine optimal monetary policy in a nonmonetary economy, which introduces an inflation-stabilization bias because the demand for money creates a motive to stabilize nominal interest rates rather than inflation. More strikingly, these studies oversimplify the behaviors of the fiscal authority by only considering the lump-sum taxation and ignoring distortionary taxations and government debts. As indicated by Schmitt-Grohe and Uribe (2007), these studies implicitly assume that the government always follows the balanced budget rule and, thus, adopt Leeper's (1991) passive fiscal policy, which is inconsistent with fiscal policy practices in most emerging market economies. For example, Guo et al. (2011) identify an active fiscal policy in China before 1998. Moreover, one strand of the literature has shown that, given monetary policy, the determinacy properties of inflation or exchange rates depend on the nature of fiscal policy (for example, Daniel 2001;Leeper 1991). Hence, the fis...

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“…A recent study on the same subject reports very similar pass-through coefficients in Turkey: 50 percent for the WPI inflation and 40 percent for the CPI inflation (Leigh and Rossi, 2002). Devereux and Lane (2003) showed that if the exchange rate pass-through is low, both output volatility and inflation volatility in a floating exchange rate regime may be lower than under a fixed exchange rate regime. They conclude that a low rate of exchange rate pass-through may be an important prerequisite for the success of inflation targeting in emerging markets.…”

Section: Also Showed That Impulse-response Functions From the Var Estmentioning

confidence: 99%

The Policy Challenge with Floating Exchange Rates: Turkey’s Recent Experience

Selçuk

2005

Open Econ Rev

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This paper evaluates the developments in the Turkish economy in light of the Central Bank of Turkey's (CBT) policies during a recent period of floating exchange rate system (March 2001-July 2003). It is found that the CBT was effective in containing volatility and reducing the average inflation rate while there was a strong recovery of output. However, there are accumulated risks in the economy. Particularly, the extreme appreciation of the Turkish lira during this period and the record level of real interest rates give the impression that the current state of the economy is fragile. Unless the government accelerates the structural reform process and pursues sound fiscal policies to reduce the public sector borrowing requirement and the debt ratio, an adverse shock to the system may trigger a reversal of fortune.Imagine an economy with an ever-rising domestic debt and record real interest rates, a high and persistent inflation, an extremely weak and shallow banking sector (occasionally, with some corrupt bankers), political instability, and a geographical location with constant turmoil in neighboring countries. On top of this, add a dramatic collapse of a fixed exchange rate based stabilization program which resulted in a market-forced devaluation followed by a floating exchange rate regime. Is it possible to conduct a policy such that the volatility of the exchange rate may be contained and the implicit inflation targeting may result in significantly lower inflation rates while real output growth picks up? The recent developments in the Turkish economy show that the answer is yes but with a significant risk remaining in the economy.February 19, 2001 was a major turning point in Turkish political and economic history. That day, Turkish Prime Minister Bulent Ecevit announced that there was a serious "dispute'' between himself and the country's President. He further emphasized that "of course, this is a serious political crisis'' without elaborating the future of the government or the ongoing stabilization program which aimed at lowering inflation with a fixed nominal exchange rate depreciation. The same day the stock market dived 18 percent and the Central Bank of

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Exchange Rates and Monetary Policy in Emerging Market Economies

Cited by 135 publications

References 39 publications

External Constraints on Monetary Policy and the Financial Accelerator

External Constraints on Monetary Policy and the Financial Accelerator

The Fiscal-Monetary Policy Mix and Exchange Rate Stability: A Dynamic Stochastic General Equilibrium Model With Chinese Characteristics

The Policy Challenge with Floating Exchange Rates: Turkey’s Recent Experience

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