Overcoming the Fear of Free Falling: Monetary Policy Graduation in Emerging Markets
Developing countries have typically pursued procyclical macroeconomic policies, which tend to amplify the underlying business cycle (the "when-it-rains-it-pours" phenomenon). There is, however, evidence to suggest that about a third of developing countries have shifted from procyclical to countercyclical fiscal policy over the last decade. We show that the same is true of monetary policy: around 35 percent of developing countries have become countercyclical over the last decade. We provide evidence that links procyclical monetary policy in developing countries to what we refer as the "fear of free falling;" that is, the need to raise interest rates in bad times to defend the domestic currency.
This paper was prepared for a conference on "The role of Central Banks in financial stability: How has it changed?" organized by the Federal Reserve Bank of Chicago on November 10-11, 2011. We are grateful to Pablo Federico, Agustin Roitman, and conference participants for helpful comments and suggestions. The views expressed herein are those of the authors and do not necessarily reflect the views of the National Bureau of Economic Research.