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Overshootings and Reversals: The Role of Monetary Policy

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  • Ilan Goldfajn
  • Poonam Gupta

Abstract

This paper provides evidence on the relationship between monetary policy and the exchange rate in the aftermath of currency crises taking into account the role of a fragile banking system. It analyzes a large set of currency crises that led to real exchange rate undervaluations from a sample of 80 countries in the period 1980 to 1998. First, the paper evaluates whether tight monetary policy increases substantially the probability of reversing the undervaluation through nominal appreciation of the exchange rate rather than through higher inflation. Second, using panel data, the paper estimates the relationship between real exchange rates and real interest rates. We find that tight monetary policy facilitates the reversal of the real exchange rate through nominal appreciation rather than inflation. In contrast, when the economy is also facing a banking crisis, tight monetary policy may not have the same effect.

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Bibliographic Info

Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 126.

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Date of creation: Nov 2001
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Handle: RePEc:chb:bcchwp:126

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  1. Mario Blejer & Alfredo Leone & Pau Rabanal & Gerd Schwartz, 2002. "Inflation Targeting in the Context of IMF-Supported Adjustment Programs," Central Banking, Analysis, and Economic Policies Book Series, in: Norman Loayza & Raimundo Soto & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series Editor) (ed.), Inflation Targeting: Desing, Performance, Challenges, edition 1, volume 5, chapter 10, pages 439-464 Central Bank of Chile.
  2. Kenneth Rogoff, 1992. "Traded Goods Consumption Smoothing and the Random Walk Behavior of the Real Exchange Rate," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, Institute for Monetary and Economic Studies, Bank of Japan, vol. 10(2), pages 1-29, November.
  3. Graciela L. Kaminsky & Carmen M. Reinhart, 1996. "The twin crises: the causes of banking and balance-of-payments problems," International Finance Discussion Papers, Board of Governors of the Federal Reserve System (U.S.) 544, Board of Governors of the Federal Reserve System (U.S.).
  4. Ilan Goldfajn & Taimur Baig, 1999. "Monetary policy in the aftermath of currency crisis: the case of Asia," Textos para discussão 399, Department of Economics PUC-Rio (Brazil).
  5. Drazen, Allan & Masson, Paul R, 1994. "Credibility of Policies versus Credibility of Policymakers," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 109(3), pages 735-54, August.
  6. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 84(6), pages 1161-76, December.
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Cited by:
  1. Chien-Chung Nieh & Yu-Shan Wang, 2005. "ARDL Approach to the Exchange Rate Overshooting in Taiwan," Review of Quantitative Finance and Accounting, Springer, vol. 25(1), pages 55-71, August.

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