Understanding fear of floating in emerging market countries (Thailand, India)

The purpose of this research is to understand the exchange rate policy of central banks in emerging market economies. Detailed empirical studies by Calvo and Reinhart (2000a) and Rinhart and Rogoff (2002) have shown that several emerging market countries show reluctance to allow their exchange rates to float freely. This behavior is known as "fear of floating".; This thesis comprises of three chapters. The first chapter builds a mathematical model of a small, open, emerging market economy. The numerical solution to this model is analyzed in the second chapter. The last chapter deals with empirical estimation of the model for two emerging market countries, Thailand and India.; The first and second chapters explore the idea that "fear of floating" and accompanying pro-cyclical interest rate policies observed in the case of emerging market economies may result from an optimal discretionary monetary policy in response to unanticipated shocks. These chapters also attempt to understand why different countries may show varying degrees of reluctance to float.; The model built in the first chapter has a small open economy with nominal price rigidities and endogenous capital accumulation. There are two sectors in this economy; traded and non-traded. International credit markets are assumed to be imperfect, so that only the traded sector enjoys the ability to borrow internationally in foreign currency. The firms in the traded sector could potentially hold a large proportion of their debt in foreign currency, while the liabilities of the non-traded are entirely denominated in the domestic currency. Domestic exchange rate volatility adversely affects the balance sheets of the traded sector firms, while interest rate volatility creates problems for the non-traded sector. In such a situation, the monetary authorities face a dilemma when reacting to shocks. The numerical solution of the model indicates the central bank's reaction to shocks, depends not only on the net effect of an exchange rate movements on output gap and inflation, but also on the relative weight the central bank allocates to stabilizing output in the traded sector as against the non-traded sector. A central bank that assigns higher importance to output stability in the traded goods sector also displays greater aversion for exchange rate volatility.; The third chapter in this dissertation empirically analyses the economies of Thailand and India from in the context of the analysis of the first two chapters. Quarterly data from 1999 to 2004 is used for the purpose of estimation. All data for both the countries is acquired from the respective central banks.; We make a distinction between manufacturing and non-manufacturing sectors of the two economies, the underlying assumption being that the manufacturing sector is the traded sector. The model is estimated using the full information. Surprisingly, we find that the monetary authorities behave pro-cyclically with respect to the manufacturing sector. The results show that the monetary authorities do treat the traded and non-traded sectors differently, as suggested by the model derived in chapter 1. However, we find pro-cyclical responses to output gaps in the manufacturing sectors for both Thailand and India.