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Monetary policy, exchange rate targeting and fear of floating in emerging market economies

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Abstract

This paper investigates whether central banks in emerging markets systematically respond to exchange rate movements. It estimates a structural general equilibrium model of a small open economy with an exchange rate-augmented Taylor-type rule for four countries. The results show that over the entire sample-period, South Africa and Mexico do not target the exchange rate, whereas Indonesia and Thailand do. In the 1980s and 1990s, all four countries targeted the exchange rate but in the aftermath of the Asian financial crisis, the Mexican peso crisis, and the end of apartheid, they all liberalized their exchange rate regimes, shifting toward inflation targeting.

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Notes

  1. The complete log-linearized equilibrium system is presented in the supplementary appendix.

  2. www.sju.edu/faculty/watkings/countryrisk.htm.

  3. To compute this average, I use the World Development Indicators database.

  4. The dates selected correspond with exogenous events but I also perform a likelihood ratio test to see if these events are consistent with a data generating process that yields a structural break at the date selected for each country.The results, shown in in the supplementary appendices, indicate there is strong evidence to suggest that in the mid 1990s there was a structural break in the reaction function of the central bank with respect to how they responded to exchange rate fluctuations.

  5. This is a weighted average of commercial bank loan interest rates in Thailand.

  6. The base year for the GDP deflator was 2000 and was consistent across countries.

  7. I use DYNARE to estimate the model parameters.

  8. Impulse response functions over the entire sample period, for a monetary policy shock in South Africa, are presented in supplementary appendix. The impulse response functions for all countries and shocks are similar in profile and clearly indicate that the model performs satisfactorily and yields the same predictions that are common in the New Open Economy Macroeconomics literature. See Lane (2001), Bergin (2003), and Corsetti (2008).

  9. Note that for these estimation results the starting values were similar but not the same as for the other estimation results.

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Acknowledgements

I express my gratitude to Stanley Black for his support and intellectual stimulation. I am grateful for comments provided by Richard Froyen, Neville Francis, Patrick Conway, Anusha Chari and seminar participants at the University of North Carolina at Chapel Hill. I appreciate the suggestions of the anonymous referee which have improved the paper.

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  1. School of Economics, University of Cape Town, Rondebosch, 7701, Cape Town, South Africa

    Amos C. Peters

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Peters, A.C. Monetary policy, exchange rate targeting and fear of floating in emerging market economies. Int Econ Econ Policy 13, 255–281 (2016). https://doi.org/10.1007/s10368-014-0300-0

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