Monetary Policy Responses in Emerging Market Economies

This technical report examines the influence of external funding reliance and foreign exchange (FX) market depth on monetary policy responses to external shocks in emerging market economies (EMEs) with floating exchange rate arrangements. It documents that central banks in EMEs characterized by high external foreign currency debt and shallow FX markets tend to adjust their policy rates in alignment with US monetary policy surprises, resulting in smaller exchange rate fluctuations. The report highlights the complications that arise from reliance on external financing, particularly how shallow FX markets and limits on external borrowing can disrupt standard monetary transmission mechanisms. It discusses the feedback loop created by currency mismatches and the implications for financial conditions when EME borrowers hold unhedged foreign currency liabilities. The findings suggest that policymakers in EMEs face varied responses depending on their specific vulnerabilities, and the report emphasizes the importance of understanding these dynamics for effective monetary policy formulation.