Monetary policy rules in emerging market economies: issues and evidence

by Marc Klau and Madhusudan Mohanty

Working Papers No 149
March 2004

The paper reviews the recent conduct of monetary policy and central banks' interest rate setting behaviour in emerging market economies. Using a standard open economy reaction function, we test whether central banks in emerging economies react to changes in inflation, output gaps and the exchange rate in a consistent and predictable manner. In most emerging economies the interest rate responds strongly to the exchange rate; in some, the response is higher than that to changes in the inflation rate or the output gap. The result is robust to alternative specification and estimation methods. This highlights the importance of the exchange rate as a source of shock and supports the "fear of floating" hypothesis. Evidence also suggests that in some countries the central bank's response to a negative inflation shock might be weaker than to a positive shock.