The Effect of Monetary Policy on Exchange Rates during Currency Crises: the Role of Debt, Institutions, and Financial Openness

Authors


  • We thank Helge Berger, Menzie Chinn, Sarantis Kalyvitis, Thomas Moutos, participants at the CESifo–Delphi Conference in Delphi, Greece (2006), and two anonymous referees for helpful comments. We also thank Menzie Chinn and Hiro Ito for making the Chinn and Ito (2005) index of capital account openness available.

Eijffinger: CentER, Tilburg University, RSM Erasmus University, CESifo, and CEPR, PO Box 90153, 5000 LE Tilburg, The Netherlands. Tel: +31-(0)13-4662411; E-mail: s.c.w.eijffinger@uvt.nl. Goderis (corresponding author): Centre for the Study of African Economies, Department of Economics, University of Oxford, Manor Road, Oxford OX1 3UQ, UK. Tel: +44-(0)1865-271074; E-mail: Benedikt.Goderis@economics.ox.ac.uk.

Abstract

This paper empirically examines the effect of monetary policy on exchange rates during currency crises. We find strong evidence that raising the interest rate: (i) has larger adverse balance sheet effects and is therefore less effective in countries with high domestic corporate short-term debt; (ii) is more credible and therefore more effective in countries with high-quality institutions; (iii) is more credible and therefore more effective in countries with high external debt; and (iv) is less effective in countries with high capital account openness. Our results support the idea that the effect of monetary policy depends on its impact on fundamentals, as well as its credibility, as suggested in the recent theoretical literature.

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