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

24 Pages Posted: 23 May 2007 Last revised: 19 Sep 2009

See all articles by Sylvester C. W. Eijffinger

Sylvester C. W. Eijffinger

Tilburg University (CentER) - Department of Economics; CESifo (Center for Economic Studies and Ifo Institute); Centre for Economic Policy Research (CEPR)

Benedikt Goderis

The Netherlands Institute for Social Research|SCP

Date Written: November 5, 2007

Abstract

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.

Keywords: currency crisis, institutions, monetary policy, short-term debt, external debt, capital account openness

JEL Classification: E52, E58

Suggested Citation

Eijffinger, Sylvester C. W. and Goderis, Benedikt, The Effect of Monetary Policy on Exchange Rates During Currency Crisis: The Role of Debt, Institutions and Financial Openness (November 5, 2007). Available at SSRN: https://ssrn.com/abstract=987778 or http://dx.doi.org/10.2139/ssrn.987778

Sylvester C. W. Eijffinger

Tilburg University (CentER) - Department of Economics ( email )

P.O. Box 90153
Tilburg, 5000 LE
Netherlands
+31 13 466 2411 (Phone)
+31 13 466 3042 (Fax)

CESifo (Center for Economic Studies and Ifo Institute)

Poschinger Str. 5
Munich, DE-81679
Germany

HOME PAGE: http://www.CESifo.de

Centre for Economic Policy Research (CEPR)

London
United Kingdom

Benedikt Goderis (Contact Author)

The Netherlands Institute for Social Research|SCP ( email )

Rijnstraat 50
The Hague, 2515
Netherlands

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