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Real Sector Shocks and Monetary Policy Responses in a in a financially vulnerable Emerging Economy

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  • Ramkishen S. Rajan

Abstract

When analyzing the appropriate response for monetary policy during a currency crisis it is important to keep in mind two distinct channels: (a) the impact of raising interest rates on exchange rates; and (b) the direct impact of exchange rate changes on output. The first pertains to the monetary side of the economy as given by the interest parity condition, while the second pertains to the real side of the economy. The interaction between these two legs of the economy derives the equilibrium output and exchange rate in the economy. This paper expands on the Aghion,Bacchetta and Banerjee (2000) monetary model, with nominal rigidities and foreign currency debt playing to examine the interaction between the real and monetary sides of the economy to analyze the impact of monetary policy on the real economy. To preview the main conclusion, we find that the impact of monetary policy on exchange rate and output depends largely on the shape of the W-curve, which is theoretically ambiguous. This in turn suggests that the appropriate monetary policy response could vary between countries at any point in time, or for a particular country between two different periods.

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  • Ramkishen S. Rajan, 2006. "Real Sector Shocks and Monetary Policy Responses in a in a financially vulnerable Emerging Economy," Working Papers id:354, eSocialSciences.
    • Handle: RePEc:ess:wpaper:id:354
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    1. Taimur Baig & Ilan Goldfajn, 2002. "Monetary Policy in the Aftermath of Currency Crises: The Case of Asia," Review of International Economics, Wiley Blackwell, vol. 10(1), pages 92-112, February.
    2. Caporale, Guglielmo Maria & Cipollini, Andrea & Demetriades, Panicos O., 2005. "Monetary policy and the exchange rate during the Asian crisis: identification through heteroscedasticity," Journal of International Money and Finance, Elsevier, vol. 24(1), pages 39-53, February.
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    Cited by:

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    2. Talavera, Oleksandr & Tsapin, Andriy & Zholud, Oleksandr, 2012. "Macroeconomic uncertainty and bank lending: The case of Ukraine," Economic Systems, Elsevier, vol. 36(2), pages 279-293.
    3. Tkalec, Marina & Vizek, Maruška & Verbič, Miroslav, 2014. "Balance sheet effects and original sinners’ risk premiums," Economic Systems, Elsevier, vol. 38(4), pages 597-613.

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