Development and Finance from issue 2011/1

Gergő Motyovszki

The Role of Exchange Rate in the Monetary Policy of Emerging Economies

- Abstract -

Monetary policy in emerging countries is very sensitive to exchange rate movements in spite of the general abandonment of previously applied fixed exchange rate arrangements that produces the fear of floating phenomenon. Mostly the financial stability aspect is responsible for this reaction, because the existence of high currency mismatch threats the financial sector besides price stability concerns. Fear of floating, however, further strengthens the existence of these factors. In order to break out from this circle a monetary policy anchoring inflationary expectations to inflation target, active communication and strong fiscal and financial institutions are needed.

During the nineties several emerging countries faced serious currency crisis the reasons of which were mostly the rigidities of pegged exchange rates. In these economies a clear move towards more flexible arrangements and the introduction of inflation targeting can be observed. Despite of this in the majority of emerging markets the fear of floating is present, these countries do not let free float and consider financial stability aspects as well.

The strengthening credibility of inflation targeting monetary policy helps anchoring inflationary expectations and the resulting more flexible exchange rate mechanism controls effectively the incentives for indebtedness in foreign currency. For controlling foreign currency borrowings a more active intervention of the financial regulatory institutions is needed. During the transition period the necessary management of exchange rate should be communicated very effectively by the monetary authority making it clear that in short run the volatility of exchange rate movements should be controlled, but it does not have exchange rate target and in long run it leaves to the market forces to reach its equilibrium.

Gergő Motyovszki, student at the Corvinus University of Budapest
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