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Incentives from exchange rate regimes in an institutional context

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  • Ashima Goyal

    (Indira Gandhi Institute of Development Research)

Abstract

In a simple open economy macromodel, calibrated to the typical institutions and shocks of a densely populated emerging market economy, it is shown that a monetary stimulus preceding a temporary supply shock can abort inflation at minimum output cost, since of the appreciation of exchange rates, accompanying a fall in interest rates and rise in output. Analytic results obtained for two periods are generalized through simulations and validated through estimation. The results imply that one instrument can, in these conditions, achieve both domestic output and exchange rate objectives, since it creates correct incentives for foreign exchange traders who make profits in supporting the policy. Such a policy response is compatible with political constraints; it also imparts limited volatility to the nominal exchange rate around a trend competitive rate, thus encouraging hedging and deepening markets. But strategic interactions imply the optimal policy need not be chosen; supporting institutions are required to coordinate monetary, fiscal policy, and markets to the optimal equilibrium. The analysis gives useful degrees of freedom for Asian emerging markets migrating to exchange rate regimes compatible with more openness.

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Bibliographic Info

Paper provided by Indira Gandhi Institute of Development Research, Mumbai, India in its series Indira Gandhi Institute of Development Research, Mumbai Working Papers with number 2006-015r.

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Length: 31 pages
Date of creation: Dec 2006
Date of revision:
Handle: RePEc:ind:igiwpp:2006-015r

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Keywords: Emerging market economy; Mundell-Fleming; monetary policy; FX market; supply shocks;

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References

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  1. Olivier Jeanne & Andrew K. Rose, 2002. "Noise Trading And Exchange Rate Regimes," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 117(2), pages 537-569, May.
  2. Svensson, Lars E O, 1998. "Open-Economy Inflation Targeting," CEPR Discussion Papers, C.E.P.R. Discussion Papers 1989, C.E.P.R. Discussion Papers.
  3. Ghosh, Atish R., 2002. "Central bank secrecy in the foreign exchange market," European Economic Review, Elsevier, Elsevier, vol. 46(2), pages 253-272, February.
  4. Ashima Goyal & A. K. Jha, 2005. "Dictatorship, Democracy and Institutions: Macropolicy in China and India," Working Papers id:264, eSocialSciences.
  5. Goyal, Ashima, 2002. "Coordinating monetary and fiscal policies: a role for rules?," MPRA Paper 29200, University Library of Munich, Germany.
  6. Bhattacharya, Utpal & Weller, Paul, 1997. "The advantage to hiding one's hand: Speculation and central bank intervention in the foreign exchange market," Journal of Monetary Economics, Elsevier, Elsevier, vol. 39(2), pages 251-277, July.
  7. Piketty, Thomas & Banerjee, Abhijit & Aghion, Philippe, 1997. "Dualism and macroeconomic volatility," CEPREMAP Working Papers (Couverture Orange) 9720, CEPREMAP.
  8. Robert H. Bates & Avner Greif & Margaret Levi & Jean-Laurent Rosenthal, 1998. "Analytic Narratives," Economics Books, Princeton University Press, Princeton University Press, edition 1, volume 1, number 6355.
  9. Goyal, Ashima & Pujari, Ayan Kumar, 2005. "Identifying long run supply curve of India," MPRA Paper 24021, University Library of Munich, Germany.
  10. Richard K. Lyons, 2006. "The Microstructure Approach to Exchange Rates," MIT Press Books, The MIT Press, The MIT Press, edition 1, volume 1, number 026262205x, December.
  11. Gilles Oudiz & Jeffrey Sachs, 1985. "International Policy Coordination In Dynamic Macroeconomic Models," NBER Chapters, National Bureau of Economic Research, Inc, in: International Economic Policy Coordination, pages 274-330 National Bureau of Economic Research, Inc.
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Citations

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Cited by:
  1. Ashima Goyal, 2007. "A General equilibrium open economy model for emerging markets: Monetary policy with a dualistic labor market," Indira Gandhi Institute of Development Research, Mumbai Working Papers, Indira Gandhi Institute of Development Research, Mumbai, India 2007-016, Indira Gandhi Institute of Development Research, Mumbai, India.
  2. Ashima Goyal, 2011. "History of monetary policy in India since independence," Indira Gandhi Institute of Development Research, Mumbai Working Papers, Indira Gandhi Institute of Development Research, Mumbai, India 2011-018, Indira Gandhi Institute of Development Research, Mumbai, India.
  3. Ashima Goyal, 2010. "The Future of Financial Liberalization in South Asia," Finance Working Papers 22051, East Asian Bureau of Economic Research.
  4. Ashima Goyal, . "Inflationary Pressures in South Asia," MPDD Working Paper Series, United Nations Economic and Social Commission for Asia and the Pacific (ESCAP) WP/11/14, United Nations Economic and Social Commission for Asia and the Pacific (ESCAP).
  5. Goyal, Ashima, 2012. "Propagation Mechanisms in Inflation: Governance as key," MPRA Paper 46360, University Library of Munich, Germany.
  6. Ashima Goyal, 2008. "The Structure of Inflation, Information and Labour Markets - Implications for monetary policy," Macroeconomics Working Papers 22378, East Asian Bureau of Economic Research.
  7. Mishra, Ankita & Mishra, Vinod, 2012. "Evaluating inflation targeting as a monetary policy objective for India," Economic Modelling, Elsevier, Elsevier, vol. 29(4), pages 1053-1063.
  8. Ashima Goyal, 2008. "The Natural Interest Rate in Emerging Markets," Working Papers id:1675, eSocialSciences.
  9. Goyal, Ashima, 2006. "Macroeconomic policy and the exchange rate: working together?," MPRA Paper 27768, University Library of Munich, Germany.

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