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Fear of Floating: An optimal discretionary monetary policy analysis

  • Madhavi Bokil

    (Clark University)

This paper explores the idea that “Fear of Floating” and accompanying pro-cyclical interest rate policies observed in the case of some emerging market economies may be justified as an optimal discretionary monetary policy response to shocks. The paper also examines how the differences in monetary policies may lead to different degrees of this fear. These questions are addressed with a small open economy, new- Keynesian model with endogenous capital accumulation and sticky prices. The economy consists of two sectors- traded and non-traded. International credit markets are assumed to be imperfect, so that only the traded sector enjoys the ability to borrow internationally in foreign currency. The firms in the traded sector could potentially hold a large proportion of their debt in foreign currency, while the liabilities of the non-traded sector firms are entirely denominated in the domestic currency. Domestic exchange rate volatility adversely affects the balance sheets of the traded sector firms, while interest rate volatility creates problems for the firms in the non-traded sector. In such a situation, the monetary authorities face a dilemma when reacting to shocks. The numerical solution of the model indicates that the central bank’s reaction to shocks depends not only on the net effect of exchange rate movements on output gap and inflation, but also on the relative weight the central bank allocates to stabilizing output in the traded sector as against the non-traded sector. A central bank that assigns relatively higher importance to output stability in the traded goods sector also displays greater aversion for exchange rate volatility.

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File URL: http://econwpa.repec.org/eps/if/papers/0510/0510002.pdf
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Paper provided by EconWPA in its series International Finance with number 0510002.

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Length: 62 pages
Date of creation: 04 Oct 2005
Date of revision:
Handle: RePEc:wpa:wuwpif:0510002
Note: Type of Document - pdf; pages: 62
Contact details of provider: Web page: http://econwpa.repec.org

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  1. Michael B. Devereux & Philip R. Lane, 2000. "Exchange Rates and Monetary Policy in Emerging Market Economies," Working Papers 072000, Hong Kong Institute for Monetary Research.
  2. Bernanke, Ben & Gertler, Mark & Gilchrist, Simon, 1996. "The Financial Accelerator and the Flight to Quality," The Review of Economics and Statistics, MIT Press, vol. 78(1), pages 1-15, February.
  3. Amartya Lahiri & Carlos A. Végh, 2002. "Living with the Fear of Floating: An Optimal Policy Perspective," NBER Chapters, in: Preventing Currency Crises in Emerging Markets, pages 663-704 National Bureau of Economic Research, Inc.
  4. Guillermo A. Calvo & Carmen M. Reinhart, 2002. "Fear Of Floating," The Quarterly Journal of Economics, MIT Press, vol. 117(2), pages 379-408, May.
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  9. Reinhart, Carmen & Calvo, Guillermo, 2001. "Fixing for your life," MPRA Paper 13873, University Library of Munich, Germany.
  10. Philippe Aghion & Philippe Bacchetta & Abhijit Banerjee, 1999. "Capital Markets and the Instability of Open Economies," Working Papers 99.01, Swiss National Bank, Study Center Gerzensee.
  11. Bernanke, Ben S. & Gertler, Mark & Gilchrist, Simon, 1999. "The financial accelerator in a quantitative business cycle framework," Handbook of Macroeconomics, in: J. B. Taylor & M. Woodford (ed.), Handbook of Macroeconomics, edition 1, volume 1, chapter 21, pages 1341-1393 Elsevier.
  12. Thomas Lubik & Frank Schorfheide, 2003. "Do Central Banks Respond to Exchange Rate Movements? A Structural Investigation," Economics Working Paper Archive 505, The Johns Hopkins University,Department of Economics.
  13. Kempf, Hubert & Gilchrist, Simon & Hairault, Jean-Olivier, 2002. "Monetary policy and the financial accelerator in a monetary union," Working Paper Series 0175, European Central Bank.
  14. Aaron Tornell & Frank Westermann, 2002. "The Credit Channel in Middle Income Countries," NBER Working Papers 9355, National Bureau of Economic Research, Inc.
  15. Jeffrey A. Frankel, 2003. "Experience of and Lessons from Exchange Rate Regime in Emerging Economies," NBER Working Papers 10032, National Bureau of Economic Research, Inc.
  16. Richard Dennis, 2003. "Inferring policy objectives from economic outcomes," Working Paper Series 2003-05, Federal Reserve Bank of San Francisco.
  17. Eric Parrado & Andres Velasco, 2002. "Optimal Interest Rate Policy in a Small Open Economy," NBER Working Papers 8721, National Bureau of Economic Research, Inc.
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