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Real Sector Shocks and Monetary Policy Responses in a Financially Vulnerable Emerging Economy

Listed author(s):
  • Ramkishen S. Rajan
  • Makarand Parulkar

When analyzing the appropriate response for monetary policy during a currency crisis, it is important to keep in mind two distinct channels: the effect of raising interest rates on exchange rates and the direct effect of exchange rate changes on output. The first pertains to the monetary side of the economy as given by the interest parity condition. The second pertains to the real side of the economy. The interaction between these two parts of the economy derives the equilibrium output and exchange rate in the economy. This paper expands on the Aghion et al. (2000) monetary model with nominal rigidities and foreign currency debt, to examine the interaction between the real and monetary sides of the economy and to analyze the effect of monetary policy on the real economy. We find that the effect of monetary policy on exchange rate and output is theoretically ambiguous. This in turn suggests that the appropriate monetary policy response could vary among countries at any point in time, or for a particular country between two different periods.

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Article provided by M.E. Sharpe, Inc. in its journal Emerging Markets Finance and Trade.

Volume (Year): 44 (2008)
Issue (Month): 3 (May)
Pages: 21-33

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Handle: RePEc:mes:emfitr:v:44:y:2008:i:3:p:21-33
Contact details of provider: Web page: http://mesharpe.metapress.com/link.asp?target=journal&id=111024

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  1. Peter J. Montiel, 2003. "Tight Money in a Post-Crisis Defense of the Exchange Rate: What Have We Learned?," World Bank Research Observer, World Bank Group, vol. 18(1), pages 1-23.
  2. Aghion, Philippe & Bacchetta, Philippe & Banerjee, Abhijit, 2000. "A simple model of monetary policy and currency crises," European Economic Review, Elsevier, vol. 44(4-6), pages 728-738, May.
  3. Kristin J Forbes, 2002. "How Do Large Depreciations Affect Firm Performance?," IMF Staff Papers, Palgrave Macmillan, vol. 49(Special i), pages 214-238.
  4. Rupa Duttagupta & Antonio Spilimbergo, 2004. "What Happened to Asian Exports During the Crisis?," IMF Staff Papers, Palgrave Macmillan, vol. 51(1), pages 1-4.
  5. Ratna Sahay & Deepak Mishra & Poonam Gupta, 2003. "Output Response to Currency Crises," IMF Working Papers 03/230, International Monetary Fund.
  6. Goderis, Benedikt & Ioannidou, Vasso P., 2008. "Do high interest rates defend currencies during speculative attacks New evidence," Journal of International Economics, Elsevier, vol. 74(1), pages 158-169, January.
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