INTRODUCTION

One of the most controversial issues that has emerged in the aftermath of the Asian financial crisis has been the appropriate response of monetary policy. Following the abandonment of exchange rate pegs, currencies depreciated rapidly in Thailand, Malaysia, Indonesia, Korea, and the Philippines. These depreciations appeared to be very adverse in their consequences, leading not only to somewhat higher inflation but also to banking sector distress and economic recession as falling currencies led to balance–sheet effects that exacerbated already existing financial sector problems. Consequently, some observers – and notably the IMF – have argued that a significant tightening of monetary policy was necessary in order to stabilize the exchange rate, restore confidence, and lay the groundwork for an eventual recovery of economic activity. Conversely, a substantial number of other economists contend that when balance–of– payments crises occur simultaneously with financial sector crises, as was the case in Asia, a tightening of monetary policy may be counterproductive. These “revisionists” argue that raising interest rates may further reduce investor confidence and lead to further weakening – not strengthening – of domestic currencies by reducing the ability of borrowers to repay loans and thereby weakening the banking system.

Roughly three years after the Asian financial crisis started, this debate remains unresolved. A key reason for this is that it is extremely difficult to use historical experience to identify the impact of monetary policy on the exchange rate.