Exchange Rates and Monetary Policy in Emerging Market Economies

IIIS Discussion Paper No. 36

HKIMR Working Paper No. 7/2000

59 Pages Posted: 8 Jun 2005

See all articles by Michael B. Devereux

Michael B. Devereux

University of British Columbia (UBC) - Department of Economics; Centre for Economic Policy Research (CEPR)

Philip R. Lane

Trinity College (Dublin) - Department of Economics; Centre for Economic Policy Research (CEPR); Central Bank of Ireland

Juanyi Xu

University of British Columbia (UBC) - Department of Economics

Multiple version iconThere are 3 versions of this paper

Date Written: August 2004

Abstract

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.

Keywords: Monetary policy, exchange rate pass-through, balance sheet constraints

JEL Classification: F0, F4

Suggested Citation

Devereux, Michael B. and Lane, Philip R. and Xu, Juanyi, Exchange Rates and Monetary Policy in Emerging Market Economies (August 2004). IIIS Discussion Paper No. 36; HKIMR Working Paper No. 7/2000. Available at SSRN: https://ssrn.com/abstract=739024 or http://dx.doi.org/10.2139/ssrn.739024

Michael B. Devereux (Contact Author)

University of British Columbia (UBC) - Department of Economics ( email )

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604-822-2542 (Phone)
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Centre for Economic Policy Research (CEPR)

London
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Philip R. Lane

Trinity College (Dublin) - Department of Economics ( email )

Trinity College
Dublin 2
Ireland
+353 1 608 2259 (Phone)
+353 1 677 2503 (Fax)

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Central Bank of Ireland ( email )

P.O. Box 559
Dame Street
Dublin, 2
Ireland

Juanyi Xu

University of British Columbia (UBC) - Department of Economics ( email )

997-1873 East Mall
Vancouver, BC V6T 1Z1
Canada

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