Monetary Policy and the exchange rate during the Asian crisis: identification through heteroscedasticity

This paper examines whether a monetary policy tightening (i.e., an increase in the domestic interest rate) was successful in defending the exchange rate from speculative pressures during the Asian financial crisis. We estimate a bivariate VECM for four Asian countries, and improve upon existing studies in two important ways. First, by using a long data span we are able to compare the effects of an interest rate rise on the nominal exchange rate during tranquil and turbulent periods. Second, we take into account the endogeneity of interest rates and identify the system by exploiting the heteroscedasticity properties of the relevant time series, following Rigobon [Identification through heteroscedasticity. Review of Economics and Statistics, in press]. We find that while tight monetary policy helped to defend the exchange rate during tranquil periods, it had the opposite effect during the Asian crisis.