Exchange rate pass-through and the monetary regime in developing countries and emerging economies: Is there a link

It is generally accepted that the aim of monetary policy is to achieve price stability. However, the question of which regime is best at achieving this goal (especially in developing countries) is an on going debate in international finance. In the aftermath of the financial crises of the 1980s and 1990s the consensus among economists was that, in a world of increasing capital mobility and technological advancement, intermediate regimes are no longer viable and that countries need to adopt either an extremely fixed or fully flexible regime. In an attempt to gain policy credibility and lower inflation rates, some developing and emerging market economies are abandoning their intermediate exchange rate regimes and are embracing extremely fixed regimes such as a currency board, monetary union, and official dollarization as these fixed regimes tie the hands of government and increase fiscal discipline.;According to Taylor (2000), the degree of exchange rate pass through is positively related to the inflation environment such that a credible monetary regime that is able to lower inflation and inflation expectations should also experience a lower degree of exchange rate pass through into prices. A test of the Taylor hypothesis for developing and emerging countries can, therefore, offer a means of assessing the performance of the different monetary regimes in these countries. Using both time series and panel data regression estimation techniques I empirically test the link between exchange rate pass through and the monetary regime in a sample of fifty developing and emerging countries over the period 1980 to 2005. The results of my study show that, while the type of regime does not matter for exchange rate pass through, pass through does tend to be lower in more credible low inflation regimes. The results also show that, in general, extremely fixed regimes do not significantly enhance credibility; where as other regimes (e.g. conventional fixed pegs and inflation targeting regimes) with credibly low inflation rates do. Intermediate exchange rate regimes may, therefore, still be a viable option for developing countries and should thus not be ruled out.