Fear of Floating: An optimal discretionary monetary policy analysis

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.