Exchange Rate-Augmented Taylor Rule : New Perspective in a Set of Emerging Market Economies

This paper ascertains the effect of changes in the exchange rate movements on domestic interest rate, using monthly data from a set of emerging market inflation targeting (IT) countries and non-IT countries. Central banks respond to exchange rate movements in addition to the other core variables, namely the inflation gap and the output gap. In this study, no evidence was found to support the fear-to-float phenomenon. In addition, countries with a high degree of financial openness are more responsive to movements in the exchange rate, but this has weakened the effectiveness of disinflationary policy. This suggests that policymakers should act pre-emptively and an exchange rate adjustment is essential as an alternative policy choice, in the calculus of formulating policy rule. Policymakers can opt for a mixed strategy. The speed of adjustment to long-run equilibrium was faster, ranging from 10.25-19.18 months, when the heterogenous endogenous break and persistency were accounted for