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Overshootings and Reversals: The Role of Monetary Policy

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  • Ilan Goldfajn
  • Poonam Gupta

Abstract

This paper provides evidence on the relationship between monetary policy and the exchange rate in the aftermath of currency crises taking into account the role of a fragile banking system. It analyzes a large set of currency crises that led to real exchange rate undervaluations from a sample of 80 countries in the period 1980 to 1998. First, the paper evaluates whether tight monetary policy increases substantially the probability of reversing the undervaluation through nominal appreciation of the exchange rate rather than through higher inflation. Second, using panel data, the paper estimates the relationship between real exchange rates and real interest rates. We find that tight monetary policy facilitates the reversal of the real exchange rate through nominal appreciation rather than inflation. In contrast, when the economy is also facing a banking crisis, tight monetary policy may not have the same effect.

Suggested Citation

  • Ilan Goldfajn & Poonam Gupta, 2001. "Overshootings and Reversals: The Role of Monetary Policy," Working Papers Central Bank of Chile 126, Central Bank of Chile.
    • Handle: RePEc:chb:bcchwp:126
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    1. Taimur Baig & Ilan Goldfajn, 2002. "Monetary Policy in the Aftermath of Currency Crises: The Case of Asia," Review of International Economics, Wiley Blackwell, vol. 10(1), pages 92-112, February.
    2. Mario I. Blejer & Alfredo M. Leone & Pau Rabanal & Gerd Schwartz, 2002. "Inflation Targeting in the Context of IMF-Supported Adjustment Programs," IMF Staff Papers, Palgrave Macmillan, vol. 49(3), pages 1-2.
    3. Kenneth Rogoff, 1992. "Traded Goods Consumption Smoothing and the Random Walk Behavior of the Real Exchange Rate," Monetary and Economic Studies, Institute for Monetary and Economic Studies, Bank of Japan, vol. 10(2), pages 1-29, November.
    4. Allan Drazen & Paul R. Masson, 1994. "Credibility of Policies Versus Credibility of Policymakers," The Quarterly Journal of Economics, President and Fellows of Harvard College, vol. 109(3), pages 735-754.
    5. Carmen M. Reinhart & Graciela L. Kaminsky, 1999. "The Twin Crises: The Causes of Banking and Balance-of-Payments Problems," American Economic Review, American Economic Association, vol. 89(3), pages 473-500, June.
    6. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, vol. 84(6), pages 1161-1176, December.
    7. Demirguc-Kunt, Asli & Detragiache, Enrica, 1997. "The determinants of banking crises : evidence from industrial and developing countries," Policy Research Working Paper Series 1828, The World Bank.
    8. Steven Radelet & Jeffrey D. Sachs, 1998. "The East Asian Financial Crisis: Diagnosis, Remedies, Prospects," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 29(1), pages 1-90.
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    1. Chien-Chung Nieh & Yu-Shan Wang, 2005. "ARDL Approach to the Exchange Rate Overshooting in Taiwan," Review of Quantitative Finance and Accounting, Springer, vol. 25(1), pages 55-71, August.
    2. Stephen Grenville, 2000. "Monetary Policy and the Exchange Rate During the Crisis," Bulletin of Indonesian Economic Studies, Taylor & Francis Journals, vol. 36(2), pages 43-60.

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