ABSTRACT

This chapter focuses on this key question: whether flexibility in exchange rate and monetary policy achieves meaningful domestic objectives. To address this question, it briefly reviews the experience of a few emerging market economies over the latter half of the 1990s. The chapter reviews the literature on how a floating exchange rate should respond to various shocks, noting how various conditions specific to emerging markets, in particular lack of credibility and financial fragility, might modify this optimal response. It examines available evidence on whether emerging market exchange rates and monetary policy appear to be useful tools of countercyclical and anti-inflationary policy. Monetary policy flexibility is valuable in two respects. First, the lack of credibility associated with a floating exchange rate may imply higher real interest rates, perhaps due to a 'peso problem' of a looming if never realized collapse. Second, unstable expectations or unruly markets may generate excessive exchange rate volatility in emerging market floats.