Essays in monetary policy and international finance

This dissertation consists of three essays that examine aspects of monetary and exchange rate policy choices in developing and emerging market economies. The first essay models limited financial market participation in less-developed economies to present a counterpoint to Milton Friedman’s well-known case for exchange rate flexibility. I analyze the welfare-maximizing choice of monetary policy in a small open economy with high financial exclusion and nominal rigidities. My findings suggest that the optimality of flexible exchange rates depends on whether agents are able to smooth consumption. When most households in an open economy are unable to hedge against international relative price fluctuations through the financial markets, nominal exchange rate targeting mitigates the resulting consumption volatility and approximates the optimal monetary policy. The second essay analyzes the appropriate choice of an exchange rate regime in agricultural commodity-exporting economies with limited labor, product, and financial market development. Welfare analysis suggests that flexible exchange rates are preferred in well-functioning domestic markets as they allow for greater relative price fluctuations, which amplify the efficient transmission mechanism of labor re-allocation in response to commodity price volatility. When labor and product markets are inflexible, however, international relative price adjustments exacerbate currency and factor misalignments. Nominal exchange rate targeting, by mitigating relative wage and price fluctuations, is preferred to exchange rate flexibility. The third essay investigates the effectiveness of restrictions on capital account transactions during periods of nominal exchange rate pressures. Using an event study approach, the paper examines the actions of the Bank of Tanzania which augmented its conventional monetary policy instruments by tightening capital account regulations three times from 2011 to 2015 in an attempt to stabilize the Tanzanian shilling. I show that while initially successful, at least over the short-run, the effectiveness of the controls declined the more they were used, raising concerns about the value of these instruments as part of the monetary policy toolkit.