FX Market Frictions in Emerging Market Economies: A Macroeconomic Assessment

Kaili Chen, Marcin Kolasa, Lindé, Jesper, Hou Wang, Pawel Zabczyk and Jianping Zhou
Authors registered in the RePEc Author Service: Jesper Lindé

No 19086, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We estimate a New Keynesian small open economy model which allows for foreign exchange (FX) market frictions and a potential role for FX interventions for a large set of emerging market economies (EMEs) and some inflation targeting (IT) advanced economy (AE) countries serving as a control group. Next, we use the estimated model to examine the empirical support for the view that interest rate policy may not be sufficient to stabilize output and inflation following capital outflow shocks, and the extent to which FX interventions (FXI) can improve policy tradeoffs. Our results reveal significant structural differences between AEs and EMEs---in particular FX market depth---leading to different transmission of capital outflow shocks which justifies occasional use of FXI in some EMEs in certain situations. Our analysis also highlights the critical importance of accounting for the endogeneity of FXI behavior when assessing FX market depth and policy tradeoffs associated with volatile capital flows in past episodes.

JEL-codes: C6 (search for similar items in EconPapers)
Date: 2024-05
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