Exchange Rate Regimes and Monetary Policies in Emerging Markets: A Showdown for Few Theoretical Misconceptions
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Abstract
The purpose of this paper is to challenge couple of dangerous theoretical misconceptions in open‐economy macro, namely, in respect to desirability or sustainability of available exchange rate re‐ gimes and inflation targeting framework and their mutual compatibility in small open economies with in‐ complete (emerging) markets. First of all, we dismiss the ruling »two corner solution« as dogma in scientific disguise. Furthermore, all the benefits of more flexible intermediate regimes (sliding currency bands) as well as empirical support of their wellbeing have been put forward. As to the monetary policies, majority of transition countries recognised superiority of inflation target‐ ing over alternative monetary concepts. However, until very recently some emerging market economies failed to realize the benefits of full‐fledged ‐let alone flexible‐ inflation targeting. In what follows, the article counters another theoretical dogma: that inflation targeting in emerging market economies must go hand in hand with fully flexible exchange rate regime. Having said that, and again contrary to the mainstream literature in the field, paper exposes some se‐ rious weaknesses of the so‐called dirty (or managed) floating as an intermediate regime: in particular, its potential sub optimality in practice and its hidden incompatibility with widespread inflation targeting strategies. Paper concludes by reiterating the inevitability of close relationship between inflation targeting and exchange rate targeting and hence suggests several possible reaction functions for the monetary authorities in emerging markets among those already laid out in the related literature.
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and Frederic Mishkin”, MIT, mimeo.
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America”, University of Maryland at College Park, mimeo.
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Corsseti, G.‐Mackowiak, B. (2003), “Fiscal Imbalances and the Dynamics of Currency Crises”, Humboldt Univesity in
Berlin Working Paper, mimeo.
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ing”, Carleton University at Ottawa, (March), mimeo.
Detken, C.‐Gaspar, V. (2003), “Maintaing Price Stability under Free‐Floating: A Fearless Way out of the Corner?”, ECB Working Paper 241.
Edwards, S. (2006), “The Relationship between Exchange Rates and Inflation Targeting Revisited”, NBER Working Paper 12163.
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Forbes, K.‐Kofman, P. (1998), “Bayesian Target Zones”, mimeo.
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Goldstein, M. (2002), “Managed Floating Plus”, Institute for International Economics, Washington DC, passim.
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rate regimes: Hard peg or free floating?”, organized by IMF Institute on March 19‐20, Washington, DC.
Mishkin, F. (2000), “Inflation Targeting in Emerging Market Countries”, NBER Working Paper 7618.
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Paper 9670.
Reinhart, C.‐Rogoff, K. (2004), “Modern History of Exchange Rate Arrangements: A Reinterpretation”, Quarterly Journal of Economics, Vol. CXIX, Issue 1, pp. 1‐48.
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Schmidt‐Hebbel, K.‐Tapia, M. (2003), »Toward Floating and Inflation Targeting in Chile«, Central Bank of Chile, (prepared for CEPT/Deutsche Bank Conference ʹManaged Floating‐ An Alternative to Two‐Corner Solution?ʹ, January 30‐31, Kronberg, Germany).
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Svensson, L. (1991*), “The Foreign Exchange Risk Premium in a Target Zone with Devaluation Risk”, CEPR Discussion
Paper 494.
Svensson, L. (1997), “Price vs. Inflation Targeting: A Free Lunch?”, On‐line paper (taken from Svensson’s Princeton web page).
Svensson, L. (2004), “Fexible Inflation Targeting: Principles and Possible Improvement”, (presentation given at Norges Bank, 25. March, Oslo, Norway).
Svensson, L.‐Woodford, M. (2003), “Implementing Optimal Policy through Inflation‐Forecast Targeting”, (paper presented at NBER Conference on Inflation Targeting, 23‐25 January, Bal Harbour, Florida), mimeo.
Taylor, J. (2001), “The role of the Exchange Rate in the Monetary Policy Rules”, The American Economic Review 91, pp.
263‐267.
Williamson, J. (1996), “The crawling band as an exchange rate regime: Lessons from Chile, Colombia and Israel”, Insti‐
tute for International Economics, Washington, DC.
Williamson, J. (1999), »Crawling Bands or Monitoring Bands: How to Manage Exchange Rates in a World of Capital
Mobility«, Policy Briefs, No. 99‐3, Institute for International Economics, Washington DC.
Williamson, J. (2000), “Designing a Middle Way between Fixed and Flexible Exchange Rates”, (paper presented on con‐
ference “Monetary and exchange rate policy: options for Egypt” that took place in Egyptian Centre for Economic Stud‐
ies, 19‐20 November, Cairo).
Williamson, J. (2000*), “Exchange Rate Regimes for Emerging Markets”, Institute for International Economics, Washing‐
ton, DC.
Woodford, M. (2003), “Interest&Prices‐Foundations of a Theory of Monetary Policy”, Princeton University Press.