Monetary policy options for mitigating the impact of the global financial crisis on emerging market economies
Introduction
One of the most important arguments against a fixed exchange rate regime is the necessity of making the stabilization of an exchange rate a primary objective of monetary policy. By doing this, monetary authorities lose autonomy in the sense that monetary policy cannot be used in order to stabilize the output or employment (domestic objectives) unless capital flows are controlled. The reasoning is rooted in the so-called trilemma or the impossible macroeconomic trinity: one cannot have the exchange rate stability, unfettered capital flows and monetary policy oriented toward domestic objectives at the same time.1 The opponents of a flexible exchange rate argue that such an arrangement contributes to uncertainty, which has an adverse effect on international trade and welfare.2
Frenkel (1999) aptly points out that, even in the face of a gradual process of international financial integration, the trilemma does not mean that a country has to choose between the exchange rate stability and monetary autonomy: “there is nothing in the existing theory, for example, that prevents a country from pursuing a managed float under which half of every fluctuation in the demand for its currency is accommodated by intervention and half is reflected in the exchange rate” (Frenkel, 1999). Taking his idea a step further, one can argue that thanks to an additional monetary policy instrument, i.e. foreign market intervention, it is possible to ease the conflict between domestic and external objectives. In other words, even if there are no barriers to capital flows, the exchange rate regime per se does not fully predetermine the stability of output and exchange rate.
The global financial crisis has entailed large economic and social costs but at the same time it has provided a unique opportunity (in a sense of a natural experiment) to investigate the effectiveness of monetary policy options adopted by emerging market economies to accommodate adverse external shocks. These economies have differed not only in the relative crisis resilience, but also in the policy option chosen to neutralize the impact of the crisis.3
The objective of this paper is to identify policy options used by monetary authorities in emerging market countries and to investigate their role in making the global financial crisis milder for their economies. The existing studies devoted to the role of monetary factors in shaping the relative crisis resilience have been focused on the type of exchange rate regime and not on the policy options actually adopted (e.g. see Berkmen et al., 2012, Blanchard et al., 2010a, Tsangarides, 2012).4 Our empirical strategy consists of two complementary steps. Firstly, we look for similarities in monetary authorities' responses to the global financial crisis. The goal is to identify similar emerging market economies in terms of monetary policy tools used to accommodate external shocks. This stage of analysis is a missing link between theoretical considerations and empirical research, and it is meant to serve as a substitute for the commonly used exchange rate regime classifications. Secondly, we examine the differences in the economic growth performance during the most intense phase of the crisis between the groups of emerging market economies. This stage is more in line with the existing empirical literature, however, our approach is focused on the effectiveness of alternative policy options oriented at crisis mitigation rather than on a sophisticated comparison between countries that peg their currencies with those that float.
The paper is structured as follows. Section 2 reviews the literature on a role of exchange rate regime during the global financial crisis and elucidates our contribution. Section 3 outlines the two-step methodological approach adopted and describes the data. Estimation results are presented in Section 4, while Section 5 provides concluding remarks.
Section snippets
Exchange rate regimes, monetary policy options and the crisis
Policy options for emerging market economies during the recent crisis are analysed by Ghosh et al. (2009). Their overall conclusion is that “there is no one-size-fits-all prescription, and the appropriate policy mix depends on particular circumstances in each country, including a number of trade-offs”. As far as monetary policy is concerned, they stress the importance of the trade-off between the benefits of lower interest rates and a depreciated currency for propping up domestic activity and
Methodology
Statistical methods of unsupervised classification are used to identify the actual monetary policy options for crisis mitigation. The groups of countries obtained are expected to include economies that have adopted similar monetary policy options. It is assumed that although the number of groups is unknown a priori, it should be neither too small nor too large. In the former case, the within group heterogeneity would be unduly large, whereas in the latter case, the regression analysis would
Monetary policy options and country groups
The objective of this part of the analysis is to discover similarities between countries with respect to monetary policy options adopted in order to mitigate the effects of the crisis. Groups are identified by comparing three variables: nominal effective exchange rate (E_RATE), interest rate spread (SPREAD), and international reserves (RESERVES). Since RESERVES have greater variability (see Table A2) and, therefore, greater discriminatory power than the other two variables, all variables are
Conclusions
One should not be surprised by inconclusive empirical results obtained in studies of the effects of exchange rate regime on relative resilience of emerging market economies to the global financial crisis. After all, the macroeconomic theory does not imply that an exchange rate regime puts firm and strict binding constraints on the macroeconomic policy. Neither does it fully predetermine which policy option of adjustment to an external economic shock will be chosen by the monetary authorities.
Acknowledgements
We are very grateful to the editor, Menzie Chinn, and two anonymous referees for their constructive comments. We thank conference participants at the 7th Professor Aleksander Zelias International Conference on Modelling and Forecasting of Socio-Economic Phenomena, for their helpful suggestions. All remaining errors are ours.
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