A "vertical" analysis of monetary policy in emerging markets

Description

During emerging market crises, domestic agents might have sufficient collateral to borrow from the other domestic agents, but they are unable to borrow from foreigners because the country, as a whole, lacks international collateral. In this setting, we show that an (ex-post) optimizing central bank's response to an external crisis is to tighten monetary policy to support the exchange rate. Although this response can be rationalized ex-post, it has negative ex-ante consequences when domestic financial markets are underdeveloped: It reduces the already insufficient private sector incentives to insure against external crises. If a central bank could commit, it should instead expand monetary policy. Indeed, lacking the willingness, credibility, or feasibility to implement an expansionary monetary policy during crises has important drawbacks. It means that the central bank must resort to other, potentially more costly instruments to address the underinsurance problem, such as capital controls and international liquidity requirements. Keywords: External shocks, domestic and international liquidity, monetary policy, interest parity departures, exchange rate overshooting, fear of floating, commitment, credibility, underinsurance. JEL Classification: E0, E4, E5, F0, F3, F4, G1.

Subjects

Links

• http://ssrn.com/abstract=306361