“Incentives from Exchange Rate Regimes in an Institutional Context”

In a simple open EME macromodel, calibrated to the typical institutions and shocks of a
densely populated emerging market economy, a monetary stimulus preceding a
temporary supply shock can lower interest rates, raise output, appreciate exchange rates,
and lower inflation. Simulations generalize the analytic result with regressions validating
the parameter values. Under correct incentives, such as provided by a middling exchange
rate regime, which imparts limited volatility to the nominal exchange rate around a trend
competitive rate, forex traders support the policy. The policy is compatible with political
constraints and policy objectives, but analysis of strategic interactions brings out cases
where optimal policy will not be chosen. Supporting institutions are required to
coordinate monetary, fiscal policy and markets to the optimal equilibrium. The analysis
contributes to understanding the key issues for countries such as India and China that
need to deepen markets in order to move to more flexible exchange rate regimes.