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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

    ()

  • Makarand Parulkar

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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.

Suggested Citation

  • Ramkishen S. Rajan & Makarand Parulkar, 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. 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.
    2. Graham Bird & Ramkishen S. Rajan, 2004. "Does devaluation lead to economic recovery or contraction? Theory and policy with reference to Thailand," Journal of International Development, John Wiley & Sons, Ltd., vol. 16(2), pages 141-156.
    3. 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.
    4. Drazen, Allan & Hubrich, Stefan, 2003. "Mixed Signals in Defending the Exchange Rate: What do the Data Say?," CEPR Discussion Papers 4050, C.E.P.R. Discussion Papers.
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    8. 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.
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    Cited by:

    1. Đorđe Đukić & Mališa Đukić, 2009. "The Global Financial Crisis and the Behaviour of Short-Term Interest Rates International and Serbian Aspects," Panoeconomicus, Savez ekonomista Vojvodine, Novi Sad, Serbia, vol. 56(4), pages 491-506, December.
    2. Tkalec, Marina & Vizek, Maruška & Verbič, Miroslav, 2014. "Balance sheet effects and original sinners’ risk premiums," Economic Systems, Elsevier, vol. 38(4), pages 597-613.
    3. 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.

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