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Exchange rate uncertainty and monetary transmission in the Philippines

This is an empirical investigation of how exchange rate volatility and monetary policy have been transmitted in a developing macro economy of the Philippines. The main thesis of this paper is that the relationship between exchange rates and interest rates are unpredictable in a globalized finance. However, under some standard assumptions, interest rates can be adjusted to smooth nominal exchange rate movements at the expense of increased volatility in other variables. An open and dynamic macroeconometric model is estimated and identified the channels of monetary policy transmission – interest rate, exchange rate and expectations and provide three innovative points. First, the specification of the exchange rate based on uncovered interest parity condition is a first formal attempt to uncover its role, along with the uncertainties it takes, to the central bank reaction function. Second, the limited role of money assumed in this model paves the way for the importance of using “policy rule” in interest rate setting. And third, the inclusion of the Government’s medium-term inflation target is a first formal shot on how the central bank may treat expectations in monetary management. Results show that although the lag structure is short, the policy interest rate elasticity to macroeconomic equilibrium is low. This leaves the impression that a slight deviation from the expected path requires a significant change in policy rate to bring the economy back to the central path. In contrast, the direct and indirect pass through effects from exchange rate to inflation are both relatively high, suggesting that it is an effective transmission mechanism. However, the influence of monetary policy on the exchange rate is limited as the standard uncovered interest parity condition is satisfied inadequately. Results show that the more volatile risk premium largely determines the behavior of exchange rate, suggesting that it may not be grounded on fundamentals. These findings indicate that the link between the interest rate and the exchange rate is highly unpredictable, leading up to uncertainty in the conduct of monetary policy.