Exchange Market Pressure and Monetary Policy

Abstract

The study employs the Girton and Roper (1977) measure of exchange market pressure (defined as the sum of exchange rate depreciation and foreign reserves outflow), to examine the interaction between exchange market pressure and monetary variables, viz. domestic credit (Reserve Money) and the interest rate. Evidence from impulse response functions suggests that domestic credit has remained the dominant tool of monetary policy for managing exchange market pressure. The increase in domestic credit upon increases in exchange market pressure (during 1991-98) was imprudent. The results suggest that fiscal needs/growth objectives might have dominated external account considerations during this period. Post 9/11 there is evidence of sterilized intervention in the forex market. The interest rate has also weakly served as the tool of monetary policy during the hay days of foreign currency deposits (1991-98). The finding implies that, for the interest rate to work as tool of monetary policy vis-a-vis exchange market pressure, a reasonable degree of capital mobility is called for.