A monetary approach to the exchange market pressure index under capital control

Abstract

The conventional Exchange Market Pressure Index (EMPI), originated from Girton and Roper (1977) and popularized by Eichengreen et al. (1994, 1995) and Weymark (1995), uses weighted average of loss of foreign reserves and depreciation of local currency to capture foreign exchange market pressure. However, it does not take into account the effect of capital control on foreign exchange market pressure. With effective capital control, the conventional EMPI tends to under- or overestimate the actual foreign exchange market pressure, depending on the magnitude of capital control. We adopt a monetary approach to derive a formula for new EMPI under capital control. Then we test the difference between the old and the new EMPI with China's data. The result shows that the conventional EMPI overestimates the actual foreign exchange market pressure by 91% in average.