Exchange Rates and Monetary Policy in Emerging Market Economies

This paper investigates the effects of exchange rate regimes and alternative monetary policy rules for an emerging market economy that is subject to a volatile external environment in the form of shocks to world interest rates, world prices and the terms of trade. Our model allows for the economy to be subject to external financing risk-premia associated with domestic net worth. We find that the particular monetary policy rule being followed is as important as whether the exchange rate is fixed or flexible. In general, there is a case for exchange rate flexibility under all shocks, but as constraints on external financing become more important, the relative benefits of monetary rules that allow for floating exchange rates tend to diminish. The benefit of exchange rate flexibility under terms of trade disturbances is quite minor, whether or not external financing constraints are important. In application to the economy of Thailand, we find that the major shocks hitting that economy come from the terms of trade. As a result, our simulation results suggest that for Thailand, the degree of exchange rate flexibility in monetary policy is likely to have only minor consequences for output stability.