Exchange Rates and Monetary Policy in Emerging Market Economies

This paper compares alternative monetary policy rules in a model of an emerging market economy that experiences external shocks to world interest rates and the terms of trade. The model is a two-sector dynamic open economy, with endogenous capital accumulation and slow price adjustment. Two key factors are highlighted in examining the response of the economy to shocks, and in the assessment of the effectiveness of monetary rules.These are: a) balance-sheet related financial frictions in capital formation; and b) delayed pass-through of changes in exchange rates to imported goods prices. We find that, while financial frictions cause a magniFcation of real and financial volatility, they have no effect on the comparison or ranking of alternative monetary policies. But the degree of exchange rate pass-through is very important for the assessment of monetary rules. With high pass-through, there is a trade-off between between real stability (in output or employment) and inflation stability. Moreover, the best monetary policy rule in this case is to stabilise non-traded goods prices. But, with delayed pass-through, the same trade off between real stability and inflation stability disappears, and the best monetary policy rule is CPI price stability Classification-Monetary Policy, Exchange Rate Pass-through, Balance Sheet Constraints

Global Monetary Policy Under a Dollar Standard

For the past four or five decades, the international monetary system has operated on a ’dollar standard’. Popular discussion suggests that this gives the US an advantage in the use of monetary policy. This Paper analyses the determination of monetary policy in a world with a dollar standard, defined here as a environment in which all traded goods prices are set in US dollars. This generates an asymmetry whereby exchange rate pass-through into the US CPI is zero, while pass-through to other countries will be positive. We show that monetary policy in such a setting does seem to accord with popular discussion. In particular, the US is essentially indifferent to exchange rate volatility in setting monetary policy, while the rest of the world places a high weight on exchange rate volatility. More importantly, in a Nash equilibrium of the monetary policy game between the US and the rest of the world, the preferences of the US dominate. That is, the equilibrium is identical to one where the US alone chooses world monetary policy. Despite this, we find surprisingly that the US loses from the dollar’s role as an international currency. Even though US preferences dominate world monetary policy, the absence of exchange rate pass-through means that US consumers are worse off than those in the rest of the world, where exchange rate pass-through operates efficiently. Finally, we derive the conditions for a dollar standard to exist.international currency; monetary policy; us dollar

Friedman Redux: Restricting Monetary Policy Rules to Support Flexible Exchange Rates

When the currency of export pricing is endogenous, there is a social benefit to exchange rate volatility that may be ignored by monetary authorities. As a result there is a welfare inferior equilibrium with zero exchange rate pass-through, and fixed exchange rates. This paper shows that there is a simple method of ruling out this equilibrium; restrict monetary authorities to respond only to domestic economic conditions

Exchange Rates and Monetary Policy in Emerging Market Economies

We compare alternative monetary policies for an emerging market economy that experiences external shocks to interest rates and the terms of trade. Financial frictions magnify volatility but do not affect the ranking of alternative policy rules. In contrast, the degree of exchange rate pass-through is critical for the assessment of monetary rules. With high pass-through, stabilising the exchange rate involves a trade-off between real stability and inflation stability and the best monetary policy rule is to stabilise non-traded goods prices. With delayed pass-through, the trade-off disappears and the best monetary policy rule is CPI price stability. Copyright 2006 Royal Economic Society.