Monetary policy spillovers in emerging economies

• Published date: 01 October 2020
• DOI: http://doi.org/10.1002/ijfe.1773
• Author: Nahiyan Faisal Azad,Apostolos Serletis
• Date: 01 October 2020

Received: 30 October 2018 Revised: 7 January 2019 Accepted: 13 September 2019

DOI: 10.1002/ijfe.1773

RESEARCH ARTICLE

Monetary policy spillovers in emerging economies

Nahiyan Faisal Azad Apostolos Serletis

Department of Economics, University of

Calgary,Calgary, Alberta, Canada

Correspondence

Apostolos Serletis, Department of

Economics, Economics University of

Calgary,Alberta, Canada.

Email: serletis@ucalgary.ca

Abstract

This paper explores for spillovers from monetary policy in the United States

to a number of emerging market economies. We estimate the bivariate struc-

tural GARCH-in-Mean VAR in the U.S. monetary policy rate and the policy rate

of each of six emerging economies that target the inflation rate—Brazil, Chile,

Mexico, Romania, Serbia, and South Africa. We also estimate the same model

in the U.S. monetary policy rate and the exchange rate (against the U.S. dol-

lar) of each of six emerging economies that target the exchange rate—Bosnia

and Herzegovina, Bulgaria, Comoros, Croatia, the Former Yugoslav Republic

of Macedonia, and Montenegro. Our evidence suggests that positive (negative)

U.S. monetary policy shocks tend to appreciate(depreciate) the currencies of the

exchange rate targeting emerging economies but have an ambiguous effect on

the policy rates of the inflation targeting emerging economies. Moreover, mon-

etary policy uncertainty in the United States leads to an increase in policy rates

in those emerging economies that target the inflation rate and to a depreciation

of the currencies of those emerging economies that target the exchange rate.

KEYWORDS

bivariate GARCH-in-Mean VAR,exchange rate targeting, inflation rate targeting

JEL CLASSIFICATION

E4; E52; E58

1INTRODUCTION

Monetary policy in the United States and the role of

the U.S. dollar as an international currency play an

important role in determining global financial conditions.

As Edwards (2018, p. 85) puts it, “even under flexible

exchange rates, there is significant policy interconnected-

ness across countries. In a highly globalized setting, even

when there are no obvious traditional reasons for rais-

ing interest rates, some central banks will follow the Fed.

This phenomenon may be called ‘policy spillover,’ and

could be the result of a number of factors, including the

desire by central banks to protect domestic currenciesfrom

‘excessive’ volatility. If this is indeed the case, then even

under flexible exchange rates there is no such a thing as

true ‘monetary independence.’” Motivated by these con-

siderations, in this paper, we explore for spillovers from

monetary policy in the United States to a number of

emerging market countries. These economies are becom-

ing extremely relevant for global economic growth, as they

account for about 70% of global growth in output and con-

sumption, and as Serletis and Azad (2018) recently put it

in the Conclusion, “the growth prospects of emerging mar-

ket economies are becoming extremely relevant for global

economic growth.”

We estimate the Elder and Serletis (2010) bivariate

structural GARCH-in-Mean VAR in the U.S. monetary

policy rate and the policy rate of each of six emerging

Int J Fin Econ. 2019;1–20. wileyonlinelibrary.com/journal/ijfe ©2019 John Wiley & Sons, Ltd. 1

664 © 2019John Wiley & Sons, Ltd. Int J Fin Econ. 2020;25:664–683.wileyonlinelibrary.com/journal/ijfe

2AZAD AND SERLETIS

economies that target the inflation rate—Brazil, Chile,

Mexico, Romania, Serbia, and South Africa. We also

estimate the same model in the U.S. monetary policy

rate and the exchange rate (against the U.S. dollar) of

each of six emerging economies that target the exchange

rate—Bosnia and Herzegovina, Bulgaria, Comoros, Croa-

tia, the Former Yugoslav Republic of Macedonia, and Mon-

tenegro. We associate the U.S. monetary policy rate VAR

residual with exogenous U.S. monetary policy shocks, use

the conditional standard deviation of the forecast error

for the change in the U.S. monetary policy rate as a mea-

sure of monetary policy uncertainty in the United States,

and investigatethe relationship between the U.S. monetary

policy rate and the policy stance in each of the emerging

economies.

Weestimate the structural (identified) GARCH-in-Mean

VARusing full information maximum likelihood, avoiding

the Pagan’s (1984) generated regressor problems associ-

ated with estimating the variance equation separately from

the conditional mean equation. We use monthly data and

two new data sets, recently compiled by the Bank for Inter-

national Settlements (BIS): one on monetary policy rates

(for 38 countries) and one on exchange rates (for 190 coun-

tries). We investigate the effects of positive and negative

U.S. monetary policy shocks and also whether monetary

policy uncertainty in the United States has had statisti-

cally significant spillover effects on each of the emerging

economies. Our evidence suggests that positive (negative)

U.S. monetary policy shocks tend to appreciate (depreci-

ate) the currencies of the exchange ratetargeting emerging

economies but have an ambiguous effect on the policy

rates of the inflation targeting emerging economies and

that monetary policy uncertainty in the United States leads

to an increase in policy rates in those emerging economies

that target the inflation rate and leads to depreciation of

the currencies of those emerging economies that target the

exchange rate.

The paper contributes in two ways to the existing liter-

ature. First, the paper uses two novel data sets, recently

made available by the BIS, to investigate for monetary pol-

icy spillovers from U.S. monetary policy toinflation target-

ing and exchange rate targeting emerging economies. The

second contribution to the existing empirical literature is

that the paper provides an empirical investigation of the

Dornbusch (1976) overshooting model for the U.S. in the

context of emerging economies. In this regard, most of the

existing studies investigate the overshooting hypothesis in

the context of advanced economies, as in Eichenbaum and

Evans (1995), and very few studies have been conducted

in the context of emerging economies. Our paper inves-

tigates the overshooting hypothesis in the context of the

U.S.economy, where the response of the U.S. dollar against

the currencies of six exchange rate targeting emerging

economies is investigated due to a monetary policy shock

in the United States.

The outline of the paper is as follows. Section 2 dis-

cusses monetary policy strategies for emerging market

economies, in particular,exchange rate targeting and infla-

tion targeting. Section 3 presents the data and discusses

their time series properties using unit root and stationarity

tests. In Section 4, we briefly explain the Elder and Ser-

letis (2010) empirical model, and in Section 5, we present

and discuss the empirical results. The last section briefly

concludes the paper.

2NOMINAL TARGETS FOR

MONETARY POLICY

What economic variable should serve as the nominal

anchor? There are several monetary policy strategies that

could be used to promote price stability, including the

money supply, the exchange rate, the inflation rate, the

price level, and nominal gross domestic product (GDP). In

what follows, we briefly discuss exchange rate targeting

and inflation targeting. In this regard, after the abandon-

ment of monetarism in the early 1980s by the Federal

Reserve in the United States and other industrialized coun-

tries around the world, because of unstable money demand

functions (due to velocity shocks), between the mid-1980s

and mid-1990s, the dominant approach for many devel-

oping countries to lower inflation rates was the use of

the exchange rate as the monetary policy target. In recent

years, however, a large number of emerging and develop-

ing economies started targeting the inflation rate and have

given their central banks greater independence, following

the success of inflation targeting in advance economies,

such as New Zealand, Canada, and the United Kingdom.

2.1 Exchange rate targeting

As already noted, a monetary policy strategy that could be

used to promote price stability is exchange rate targeting

(also referred to as an exchange rate peg). It involves fix-

ing the value of the domestic currency to that of a large,

low-inflation country (the anchor country). It requires an

easing of monetary policy when there is a tendency for

the domestic currency to appreciate and a tightening of

monetary policy when there is a tendency for the domestic

currency to depreciate. It has the advantage of increasing

international trade and investment by reducing transac-

tion costs and exchange rate risk and by preventing spec-

ulative bubbles. Moreover, if the nominal anchor of an

exchange rate target is credible (i.e., expected to be adhered

to), it helps mitigate the time inconsistency problem asso-

ciated with rule type monetary policy making.

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