The effect of monetary policy on real exchange rate misalignment

Abstract

Abstract In this paper we investigate the relationship between monetary policy and the exchange rate. Our primary goal is to analyze the effect of tight monetary policy on reversing the currency under-valuation. We look at a sample of 19 developing countries for a period of twenty years. We find tight monetary policy to be ineffective in correcting real exchange rate misalignment when governments can engage in devaluation and undertake fiscal policy in addition to monetary policy. I. Introduction IMF’s recommendation to the Asian countries, whose currencies were under attack, was to raise interest rates. IMF’s belief was that higher interest rates would stop capital flight and help rebuild investor confidence. This is a standard IMF prescription for countries experiencing currency and financial crises. Financial assistance from the IMF is usually conditional on implementation of these policies. IMF has been criticized for too quickly prescribing the old recipe without taking into account the differences in the Asian currency crises. Critics of IMF argue that when financial crises are brought about by excessive spending by fiscal authorities, tightening of monetary policies is sensible advice. But Asian countries were characterized by high savings, low inflation and budgets in surplus at the onset of the Asian crises. Their problem was not lax monetary or fiscal policy, but rather investor panic. Furman and Stiglitz (1998), Krugman (1998), Sachs and Radelet (1998), and Stiglitz (1998) provide a review of the channels through which tight monetary policy may affect the exchange rate.