Exchange Rates and Monetary Policy in Emerging Market Economies

We compare alternative monetary policies for an emerging market economy that experiences external shocks to interest rates and the terms of trade. Financial frictions magnify volatility but do not affect the ranking of alternative policy rules. In contrast, the degree of exchange rate pass-through is critical for the assessment of monetary rules. With high pass-through, stabilising the exchange rate involves a trade-off between real stability and inflation stability and the best monetary policy rule is to stabilise non-traded goods prices. With delayed pass-through, the trade-off disappears and the best monetary policy rule is CPI price stability.