DP6217 The Effect of Monetary Policy on Exchange Rates During Currency Crises: The Role of Debt, Institutions and Financial Openness

Author(s): Sylvester C. W. Eijffinger , Benedikt Goderis

Publication Date: March 2007

Keyword(s): capital account openness , currency crises , external debt , institutions , monetary policy , short-term debt

JEL(s): E52 , E58

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP6217.asp.asp

This paper examines the effect of monetary policy on the exchange rate during currency crises. Using data for a number of crisis episodes between 1986 and 2004, 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. We predict that monetary policy would have had the conventional supportive effect on the exchange rate during five of the crisis episodes in our sample, while it would have had the perverse effect during seven other episodes. For four episodes, we predict a statistically insignificant effect. 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. They also provide an explanation for the mixed findings in the empirical literature.