Exchange Rate Stabilization and Monetary Transmission

Department: Finance

Speaker: Paul Fonantier (LBS) 

Room:T022

Abstract

Conventional wisdom, rooted in the Mundellian trilemma, holds that exchange
rate stabilization constrains monetary policy. We challenge this view for emerging
markets with shallow financial markets. Across 16 emerging economies, we document
that the pass-through from policy rates to market interest rates is strongest at
intermediate levels of exchange rate volatility, and weaker under both free floats and
hard pegs—an inverted-U pattern. We rationalize it with a model of segmented financial
markets in which binding risk limits make domestic arbitrage demand inelastic.
We show that this inelasticity weakens the transmission of policy rates to market interest
rates. Exchange rate stability attracts foreign investment in local-currency assets,
which absorbs risk, relaxes the limits, and makes arbitrage demand more elastic. This
strengthens transmission and gives the central bank better control over the output
gap. Starting from a pure output-gap rule, it is always optimal to introduce some
exchange rate stabilization. However, excessive stabilization, such as a hard peg, can
backfire by raising policy rate volatility and increasing the risk borne by arbitrageurs.