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Real Sector Shocks and Monetary Policy Responses in a Financially Vulnerable Emerging Economy

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  • Ramkishen S. Rajan
  • Makarand Parulkar
Abstract
When analyzing the appropriate response for monetary policy during a currency crisis, it is important to keep in mind two distinct channels: the effect of raising interest rates on exchange rates and the direct effect of exchange rate changes on output. The first pertains to the monetary side of the economy as given by the interest parity condition. The second pertains to the real side of the economy. The interaction between these two parts of the economy derives the equilibrium output and exchange rate in the economy. This paper expands on the Aghion et al. (2000) monetary model with nominal rigidities and foreign currency debt, to examine the interaction between the real and monetary sides of the economy and to analyze the effect of monetary policy on the real economy. We find that the effect of monetary policy on exchange rate and output is theoretically ambiguous. This in turn suggests that the appropriate monetary policy response could vary among countries at any point in time, or for a particular country between two different periods.

Suggested Citation

  • Ramkishen S. Rajan & Makarand Parulkar, 2008. "Real Sector Shocks and Monetary Policy Responses in a Financially Vulnerable Emerging Economy," Emerging Markets Finance and Trade, Taylor & Francis Journals, vol. 44(3), pages 21-33, May.
    • Handle: RePEc:mes:emfitr:v:44:y:2008:i:3:p:21-33
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    1. 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.
    2. Ms. Ratna Sahay & Deepak Mishra & Mrs. Poonam Gupta, 2003. "Output Response to Currency Crises," IMF Working Papers 2003/230, International Monetary Fund.
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    9. 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.
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    2. 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.
    3. Tkalec, Marina & Vizek, Maruška & Verbič, Miroslav, 2014. "Balance sheet effects and original sinners’ risk premiums," Economic Systems, Elsevier, vol. 38(4), pages 597-613.

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