Real Sector Shocks and Monetary Policy Responses in a Financially Vulnerable Emerging Economy

Emerging Markets Finance and Trade (Impact Factor: 0.95). 01/2008; 44(3):21-33.
Source: RePEc

ABSTRACT When analyzing the appropriate response for monetary policy during a currency crisis, it is important to keep in mind two distinct channels: the effect of raising interest rates on exchange rates and the direct effect of exchange rate changes on output. The first pertains to the monetary side of the economy as given by the interest parity condition. The second pertains to the real side of the economy. The interaction between these two parts of the economy derives the equilibrium output and exchange rate in the economy. This paper expands on the Aghion et al. (2000) monetary model with nominal rigidities and foreign currency debt, to examine the interaction between the real and monetary sides of the economy and to analyze the effect of monetary policy on the real economy. We find that the effect of monetary policy on exchange rate and output is theoretically ambiguous. This in turn suggests that the appropriate monetary policy response could vary among countries at any point in time, or for a particular country between two different periods.

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    ABSTRACT: In a world of high capital mobility, the threat of speculative attack becomes a central issue of macroeconomicpolicy. While “first-generation” and “second-generation” models of speculative attacks both have considerablerelevance to particular financial crises of the 1990s, a “third-generation” model is needed to make sense of thenumber and nature of the emerging market crises of 1997-98. Most of the recent attempts to produce such amodel have argued that the core of the problem lies in the banking system. This paper sketches another candidatefor third-generation crisis modeling—one that emphasizes two facts that have been omitted from formal modelsto date: the role of companies' balance sheets in determining their ability to invest, and that of capital flows inaffecting the real exchange rate. Copyright Kluwer Academic Publishers 1999
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    ABSTRACT: Sharp exchange rate depreciations in the East Asian crisis countries (Indonesia, Korea, and Thailand) raised doubts about the efficacy of increasing interest rates to defend the currency. Using a standard monetary model of exchange rate deter- mination, this paper shows that tighter monetary policy was in fact associated with an appreciation of the exchange rate in these countries and during the Mexican currency crisis. Moreover, there is little evidence of higher real interest rates contributing to a widening of the risk premium. (JEL F31, G15, E40)


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