The role of flexible exchange rates in emerging market business cycles. Theory, evidence, policy

Business cycles in emerging market economies (EMEs) are characterised by strong volatility and procyclical exchange rates. This dissertation investigates the role of exchange rates in EM business cycles from a theoretical, empirical, and policy perspective. First, it provides a Minskyan open economy model in which exchange rate procyclicality is generated through the interaction of nominal exchange rates and investment spending. The model shows that when balance sheet effects from foreign currency debt and the important propensity are strong, endogenous cycles can emerge whose volatility increases when risk appetite for external debt rises. Second, the dissertation formalises and empirically tests three endogenous business cycle mechanisms from the Minskyan literature using bivariate vector-autoregressions. Three financial variables (the interest rate, external debt, the nominal exchange rate) and their cyclical interaction with output are tested for a data set of 13 EMEs over the period 1960-2017. There is evidence for a cycle mechanism (i) with nominal exchange rates in Chile, Israel, the Philippines and South Africa; (ii) with external debt in Mexico, the Philippines, and South Africa, and (iii) with interest rates in Argentina, Mexico, and South Africa. Third, the thesis tests the hypotheses that foreign exchange intervention (FXI) can stabilise (i) output and consumer prices and (ii) output and quity prices after external shocks. Estimating vector-autoregressions on data from 25 small open economies over the period 1990Q1-2017Q4, it employs a counterfactual analysis to assess the effectiveness of FXI on either prices or output in 21 out of 25 countries, and for a stabilising effect on share prices in 17 out of 23 counties. Overall, the thesis presents theoretical and empirical evidence that flexible exchange rates can be important drivers of EM business cycles and that exchange rate management can be stabilising