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Global standard features for monetary policy risk optimization in emerging market economies

Monetary policy challenges in Emerging Market Economies (EMEs) differ significantly from challenges faced by advanced economies. Monetary policies are responsible for providing financial stability. However, in EMEs, financial stability may be mainly dependent on capital flows. As EMEs become more integrated into international trade and finance, it is imperative to address policy challenges and their respective social and political consequences in the international community. This document aims to identify the main monetary policy challenges EMEs face and locate these challenges in broader debates around policy recommendation options. While there is no official definition of EMEs, the International Monetary Fund (IMF) identifies characteristics of emerging markets such as per capita income and participation in global trade and financial market integration.

The standard features of EMEs are; (1) Market Volatility: The economy experiences unpredictable price movements due to political instability, external price, and supply-demand shocks. There is thus a risk of fluctuations in exchange rates; (2) Lower per-capita income; (3) Growth and investment potential; (4) Implementation of policies that favor industrialization and rapid economic growth. The primary function of monetary policy is to provide financial stability. An effective monetary policy will maintain stable prices, thereby supporting conditions for long-term growth. Thus, growth and employment objectives will be reached if the policy can ensure financial stability. What are the key challenges that monetary policies in EMEs face?

While country-specific conditions will produce their specific challenges, general monetary policy challenges can be identified. Firstly, critical institutional restraints will be discussed. Central banks may lack independence which means they will tread a fine to maintain legitimacy and sovereignty under challenging stances. The operational independence of central banks may be circumscribed by constraints such as maintaining the exchange rate. Thus, there is little room to use policy tools to pursue an independent monetary policy to manage domestic activity and inflation. Fiscal dominance and unsustainable fiscal policies are significant challenges that central banks may face. Weak transmission mechanisms often hamper monetary policies in EMEs due to the underdevelopment of the financial system.

The fragile banking systems in EMEs may deter central banks from using interest rates to achieve domestic objectives. Other challenges discussed are a well-developed financial market, the lack of market integration, inflexible labor markets, and technological challenges in implementation processes. During the pandemic, EMEs introduced a wide array of unconventional monetary policies. These included asset purchases to improve market liquidity and ease market stresses. While policies have had a positive impact, the tools are still novel and come with considerable risks and challenges. Three of the challenges will be elaborated on. Firstly, EMEs need to decide how much maturity, credit, and exchange-rate risks they’re willing to take on their balance sheets.

Secondly, EMEs need to consider the dangers of fiscal dominance that may be associated with large-scale purchases by government security. Broader government challenges and political pressures may emerge if central banks support non-bank financial institutions or set up funding and lending programs to help specific sectors. The third challenge that EMEs might face is exiting these programs without triggering financial instability. Political pressure may be more acute in the post-pandemic environment of rising interest rates and high public debt. Monetary policy challenges need to be identified to recommend effective policy changes. EMEs face different policy challenges than advanced industrial economies, where financial crises often originate from internal imbalances. The financial conditions in EMEs are strongly dependent on capital flow. Thus, their monetary policies must balance the effects of aggregate demands and capital flows.

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