The Impact of Monetary Policy on Exchange Rates During Financial CrisesThis paper addresses the impact of monetary policy on exchange rates during financial crises. Some observers have argued that a tightening of monetary policy is necessary to stabilize the exchange rate, restore confidence, and lay the groundwork for an eventual recovery of economic activity. Others have argued that by raising interest rates (which reduces the ability of borrowers to repay loans and thereby weakens the banking system), tightening may further reduce investor confidence and lead to further weakening--not strengthening--of domestic currencies. This debate, which became highly charged during the Asian financial crisis, remains unresolved. A key reason is that, because of the endogeneity of interest rates with respect to exchange rates and investor expectations, it is difficult to use statistical analysis to identify the impact of monetary policy on the exchange rate. In our research, we use measures of international credit spreads and of domestic stock prices as proxies for investor concerns about creditworthiness and country risk in order to better identify the impact of monetary policies on the exchange rate. Using weekly data from Indonesia, Korea, Malaysia, the Philippines, Thailand, and Mexico, we find that credit spreads and stock prices exert significant impacts on exchange rates during financial crises, but interest rates still are not estimated to have significant effects. We conclude that while monetary policy probably does exert an important influence over exchange rates, this most likely takes place slowly, as central banks attempt to establish credibility, and over longer periods of time than can be captured in our analysis. |
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aggregate stock returns Asian crisis Asian financial crisis autocorrelation of errors bank stock returns banking sector coefficients cointegrating vector correlated country risk premium credit spreads currency values default depreciate the exchange domestic interest rates ECM estimation endogeneity problems estimation results exchange rate depreciation expected future exchange explanatory variables Federal Reserve System financial crises first-differenced first-differences floating exchange rate future exchange rate Granger-causality tests identify the impact impact of interest impact of monetary increases in interest INFDIFF inflation expectations inflation rates interest rate differential investor perceptions July 94 lagged level levels in parentheses LM significance LM test Malaysia Mexico monetary tightening nominal interest rates null hypothesis Observations 51 57 Period of observation Philippines policy on exchange rates during financial rates on exchange real exchange rate real interest rate Regression std Significance levels spreads and stock STKRET Table test for autocorrelation Thailand tightening monetary policy tightening of monetary U.S. dollar