Effects of Monetary Policy in a Fixed Exchange Rate Regime: Tranquil and Turbulent States

Abstract

This paper evaluates monetary policy effects in a fixed exchange rate regime. A fixed exchange rate regime sometimes suffers from turbulence, owing to speculative attacks or other factors that significantly change the expectations of maintaining such a regime. We, therefore, develop a vector autoregression model with a jump processes to evaluate monetary policy in both tranquil and turbulent states. We find that a contractionary monetary policy shock in the tranquil period only affects the exchange rate in the very short run. Nonetheless, the shock significantly reduces the price level and industrial production, especially for a credible peg with a wider band. During the turbulent period, the exchange rate is kept stable for one quarter when facing the same shock—while industrial production drops significantly. The findings, also shed light on the cost of successful defense of speculative attacks.