Incentives from exchange rate regimes in an institutional context

Ashima Goyal

Indira Gandhi Institute of Development Research, Mumbai Working Papers from Indira Gandhi Institute of Development Research, Mumbai, India

Abstract: In a simple open economy macromodel, calibrated to the typical institutions and shocks of a densely populated emerging market economy, it is shown that a monetary stimulus preceding a temporary supply shock can abort inflation at minimum output cost, since of the appreciation of exchange rates, accompanying a fall in interest rates and rise in output. Analytic results obtained for two periods are generalized through simulations and validated through estimation. The results imply that one instrument can, in these conditions, achieve both domestic output and exchange rate objectives, since it creates correct incentives for foreign exchange traders who make profits in supporting the policy. Such a policy response is compatible with political constraints; it also imparts limited volatility to the nominal exchange rate around a trend competitive rate, thus encouraging hedging and deepening markets. But strategic interactions imply the optimal policy need not be chosen; supporting institutions are required to coordinate monetary, fiscal policy, and markets to the optimal equilibrium. The analysis gives useful degrees of freedom for Asian emerging markets migrating to exchange rate regimes compatible with more openness.

Keywords: Emerging market economy; Mundell-Fleming; monetary policy; FX market; supply shocks (search for similar items in EconPapers)
JEL-codes: F31 F41 (search for similar items in EconPapers)
Pages: 31 pages
Date: 2006-12
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (3)

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Related works:
Working Paper: Incentives from Exchange Rate Regimes in an Institutional Context (2008)
Working Paper: Incentives from Exchange Rate Regimes in an Institutional Context (2006)
Working Paper: Incentives from exchange rate regimes in an institutional context (2005)
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