Monetary Policy and the Exchange Rate During the Asian Crisis: Identification Through Heteroscedasticity

Abstract

Abst ract Thi s paper exam i nes whet her a m onet ary pol i cy t i ght eni ng (i . e. , an i ncrease i n t he dom est i c i nt erest rat e) was successf ul i n def endi ng t he exchange rat e f rom specul at i ve pressures duri ng t he Asi an f i nanci al cri si s. W e est i m at e a bi vari at e VECM f or f our Asi an count ri es, and i m prove upon exi st i ng st udi es i n t wo i m port ant ways. Fi rst , by usi ng a l ong dat a span we are abl e t o com pare t he ef f ect s of an i nt erest rat e ri se on t he nom i nal exchange rat e duri ng t ranqui l and t urbul ent peri ods. Second, we t ake i nt o account t he endogenei t y of i nt erest rat es and i dent i f y t he syst em by expl oi t i ng t he het eroscedast i ci t y propert i es of t he rel evant t i m e seri es, as suggest ed by Sent ana and Fi orent i ni (2001). W e f i nd t hat whi l e t i ght m onet ary pol i cy hel ped t o def end t he exchange rat e duri ng t ranqui l peri ods, i t had t he opposi t e ef f ect duri ng t he Asi an cri si s.

Monetary policy, exchange rates and stock prices in the Middle East region

“…However Stiglitz (1999) argues that this relationship might not hold during periods of nancial crisis were interest rate hikes might increase the risk of bankruptcy leading to loss of con dence and capital out ows. Caporale et al (2005) examine this issue during the Asian crisis and conclude that during the crisis interest rate increases contributed to the collapse of the domestic currencies. At the same time exchange rates are usually important determinants of monetary policy stance.…”

Sources and Effectiveness of Financial Development: What We Know and What We Need to Know

“…Hence, identifying the effects of policy tightening is extremely difficult. Caporale et al (2005) exploit the heteroskedasticity properties in the relevant time-series for these variables in order to identify the system. Using a bivariate vector autoregression model, they find that while tight monetary policy helped to defend the currencies concerned during tranquil periods, it had the opposite effect during the Asian crisis.…”

Fighting Against Currency Depreciation, Macroeconomic Instability, and Sudden Stops

“…11 In this sense the rule responds to the deviation of the current depreciation rate from the depreciation target. 12 We also assume that the rule can respond positively to the deviation of the nominal depreciation rate from its target, ρ > 0, capturing the policy recommendation of the IMF policy makers; or it can react negatively, ρ < 0, describing, to some extent, the policy recommendations of the opposite view. Nevertheless we exclude the cases ρ = −1, 1.…”

“…14 Moreover we introduce separability in the utility derived from c t which will allow us to 11 For simplicity we also assume that these targets correspond to the steady-state levels of these variables. 12 Below we will consider other interest rate policies that differ in terms of the timing of the rule and on the inclusion of other arguments such as the CPI-inflation rate. 13 The reason of this is that our analysis relies on a loglinearized system of equations that describes the dynamics of the economy.…”