Essays on exchange regimes, optimal monetary policy and capital flows in emerging markets

One of the biggest challenges facing policymakers in emerging markets is the optimal management of large volumes of capital flows. This three-part dissertation studies how external borrowing affects fiscal, monetary and exchange rate policy behavior.; The first essay provides a positive analysis of the relative merits of various monetary and fiscal measures employed in the early nineties to mitigate vulnerabilities arising from large capital inflows. The paper adopts a two sector, dynamic, neo-Keynesian model in a small open economy setup. In keeping with stylized facts, the model reproduces well the consumption boom, real exchange rate appreciation and current account deficit observed under a fixed exchange rate regime. A flexible exchange rate regime results in a stronger real exchange rate appreciation, whereas a contractionary fiscal policy stabilizes the real exchange rate and the current account. The model, however, does not predict an investment-led absorption.; Following the financial crises of mid-late nineties, many emerging market countries adopted a flexible exchange rate regime, raising the question what the appropriate monetary policy rule should be. The second essay examines the normative implications of alternative policy rules such as an inflation targeting rule, a monetary targeting rule and the Taylor rule. The optimal rule, defined as the one which generates consumption volatility closest to the benchmark complete asset market model, depends upon the source of shocks and the degree of international capital market integration. Under a foreign interest rate shock, non-tradables inflation targeting most closely resembles the efficient markets whereas CPI inflation targeting does so under a domestic non-tradables productivity shock.; The third essay examines the empirical evidence for the effect of foreign currency denominated debt on exchange rate policy. I estimate the monetary policy reaction function and study its sensitivity to the net external liabilities of the banking sector in three Asian countries that have recently adopted an inflation targeting framework. Estimation results indicate that exchange rate policy is affected by debt considerations when they exceed a certain sustainable level. This finding lends support to the ‘fear of floating’ hypothesis that dollarization of liabilities prevent emerging markets from becoming true floaters.