Understanding Currency Crises and Monetary Policy Responses in Emerging Economies

Abstract

When analyzing the appropriate monetary policy response during a currency crisis, it is important to keep in mind two distinct channels: (a) the impact of changing interest rates on exchange rates; and (b) the direct impact of exchange rate changes on output. The first pertains to the monetary side of the economy as given by the interest parity condition, while the second deals with the real side of the economy. The interaction between these two legs of the economy derives the equilibrium output and exchange rate changes in the economy. Thus, the net effect of monetary policy on output and exchange rate requires consideration of both dimensions of the economy.