“The art of central banking in an emerging market is to keep enough powder dry so that when the crisis comes, you can actually respond.” — Agustín Carstens, BIS General Manager, 2018
The macroeconomic policy frameworks developed in Parts II–VI apply most cleanly to advanced economies with deep financial markets, credible central banks, stable fiscal institutions, and diversified production structures. Developing and emerging market economies (EMEs) present a substantially more challenging environment: central banks often lack credibility, exchange rates are subject to sudden stops and speculative attacks, fiscal capacity is limited by narrow tax bases and large informal sectors, financial markets are shallow, and real economies face large and persistent terms-of-trade shocks. This chapter examines how the standard frameworks must be modified for developing country contexts, and what specific policy challenges arise from each distinctive feature of the development context.
35.1 Original Sin and the Currency-Debt Trap¶
One of the most fundamental constraints on developing country macroeconomic management is the inability to borrow internationally in their own currencies — the original sin (Eichengreen and Hausmann, 2003). When a country’s external debt is denominated entirely in foreign currency (dollars, euros, yen), a real exchange rate depreciation directly raises the domestic-currency value of the debt:
where is foreign-currency debt, is the exchange rate (domestic currency per unit of foreign), and is the domestic price level. A 30% depreciation on external debt equal to 50% of GDP raises the debt burden by of GDP — an immediate, severe fiscal shock requiring no policy error, simply the result of an external shock (a global risk-off episode, a commodity price collapse, a U.S. rate increase) triggering a flight to safety.
This creates a contractionary depreciation syndrome absent in advanced economies that borrow in their own currencies. For the United States, a dollar depreciation reduces the real burden of dollar-denominated U.S. government debt — an automatic stabilizer. For countries with dollar-denominated liabilities, depreciation is destabilizing: it simultaneously erodes competitiveness (potentially helping exports) while worsening the fiscal and corporate balance sheets. The two effects conflict, and for heavily indebted countries the balance sheet channel dominates, making depreciation contractionary on net.
Managing Original Sin: Three Strategies¶
Local currency bond market development shifts currency risk from the sovereign to foreign investors who choose to hold domestic-currency bonds. Brazil, Mexico, India, Poland, and South Africa have successfully developed local-currency government bond markets, enabling the sovereign to borrow in domestic currency even from foreign investors. The prerequisites are macroeconomic credibility (investors must believe the currency will not be inflated away), rule of law (investors must believe contracts will be honored), and sufficient domestic institutional investment (pension funds, insurance companies providing a natural domestic investor base).
Reserve accumulation provides self-insurance against sudden stops. Following the 1997-98 Asian crisis, which devastated countries that lacked reserves, EME central banks dramatically built up foreign exchange reserves. China’s 450 billion, and India’s $580 billion represent massive self-insurance premia — each country paying the opportunity cost of holding low-yield foreign assets to insure against the catastrophic cost of a sudden stop without a buffer.
Dollarization and currency boards eliminate the exchange rate risk entirely by adopting a strong currency as legal tender (Ecuador, El Salvador, Panama with the dollar) or backing the domestic currency 100% with reserves (Argentina’s convertibility plan, 1991–2001; Estonia’s currency board, 1992–2010). This maximally credible commitment provides exchange rate stability at the cost of permanently abandoning monetary policy. The Argentine experience (2001 crisis and default despite the currency board) illustrates the limits: a hard peg without sufficient fiscal discipline and labor market flexibility eventually requires an unsustainable defense and a catastrophic abandonment.
35.2 Monetary Policy in Emerging Market Economies¶
High Exchange Rate Pass-Through¶
Exchange rate pass-through (ERPT) to domestic inflation is substantially higher in EMEs than in advanced economies — approximately 0.3–0.5 in EMEs versus 0.05–0.1 in advanced economies. Three structural factors drive this: a higher share of tradable goods (food and energy) in consumer baskets; weaker credibility of the inflation anchor (so that a depreciation raises inflation expectations by more); and dollar pricing of imports (so that import prices move nearly one-for-one with the exchange rate).
The policy implication: exchange rate volatility has a much larger inflation impact in EMEs, creating stronger incentives for central banks to intervene in foreign exchange markets even under nominal inflation targeting — the “fear of floating” documented by Calvo and Reinhart (2002). The extended Taylor rule for EME central banks:
where the exchange rate term captures the direct stabilization motivation for responding to exchange rate movements. This creates tension: responding to exchange rate depreciation by raising rates may stabilize inflation but deepens the recession and worsens balance sheet pressures from higher domestic interest rates on variable-rate domestic currency debt.
Credibility Building and the Sacrifice Ratio¶
In economies where central banks have historically accommodated inflation or where hyperinflation episodes have damaged credibility, the sacrifice ratio for disinflation is much higher than in credible advanced economy central banks. When agents heavily discount future monetary policy commitments (low in the behavioral NK model [Ch. 15]), the forward-looking component of the NKPC becomes negligible:
and reducing inflation by 1 percentage point requires a much larger sustained output gap than in a credible framework. The implication: credibility is not a luxury but a necessary precondition for effective monetary stabilization. Building credibility requires institutional reform (central bank independence legislation), demonstrated willingness to tolerate short-run output costs for inflation control, and consistency between monetary and fiscal policy.
Brazil’s disinflation from 2000% annual inflation in 1994 (pre-Real Plan) to 3–10% required a full monetary regime change — the introduction of a new currency (the real) backed by tight commitments — not merely interest rate adjustment. Turkey’s failed disinflation attempts in the 2000s–2010s, repeatedly abandoned under political pressure, illustrate that credibility cannot be purchased quickly and is easily destroyed.
35.3 Fiscal Policy Under Fiscal Dominance¶
Definition (Fiscal Dominance). Fiscal dominance is the monetary policy regime in which the government’s financing needs determine monetary policy: the central bank is compelled to monetize the fiscal deficit because the government cannot access alternative financing. Under fiscal dominance, monetary tightening today merely defers inflation — the public correctly anticipates that the fiscal deficit will eventually require monetization, so the price level rises immediately to reflect the present value of future money creation.
The Sargent-Wallace (1981) Unpleasant Monetarist Arithmetic showed this formally: if the central bank restricts money growth today, the resulting interest rate increase raises the cost of the debt stock; the government must eventually monetize the larger debt, generating higher inflation later. The public, anticipating this, adjusts expectations immediately, rendering the short-run tightening contractionary without yielding lasting disinflation.
The fiscal theory of the price level (Woodford, 2001) provides the general framework: the price level adjusts to ensure the real value of outstanding government debt equals the present value of future primary surpluses:
When the present value of future surpluses is insufficient to service debt, must rise to reduce the real value of — inflation is a fiscal outcome. The policy implication: successful monetary stabilization in EMEs requires simultaneous fiscal consolidation, not merely monetary tightening. This lesson was learned repeatedly in Latin American stabilizations of the 1970s–90s and formalized in Sargent’s (1982) analysis of the successful European hyperinflation stabilizations of the 1920s.
35.4 Capital Flow Management¶
Capital flows to EMEs are large, volatile, and procyclical — amplifying booms and busts. The IMF’s original position was that capital account liberalization was unambiguously desirable; the post-2008 experience has led to a more nuanced Integrated Policy Framework (IMF, 2021) acknowledging that capital flow management tools (CFMs) may be appropriate in specific circumstances.
Definition (Capital Flow Management Tool). A CFM is a policy instrument that restricts or regulates cross-border capital flows, including: reserve requirements on foreign borrowing (Chile’s encaje, 1990s); taxes on capital inflows (Brazil’s IOF financial transactions tax, 2009–12); quantitative limits on external borrowing by banks and corporates; and macroprudential measures targeting the currency and maturity structure of foreign borrowing.
When Are CFMs Justified?¶
The IMF’s Integrated Policy Framework identifies four circumstances where CFMs may be appropriate, ranked by priority:
Financial stability threats: when large capital inflows generate credit booms, asset price bubbles, and currency overvaluation that cannot be addressed through macroprudential tools alone, CFMs can lean against the cycle.
Original sin amplification: when inflows take the form of short-term dollar-denominated debt, they amplify balance sheet vulnerabilities. CFMs that favor equity over debt, or local currency over foreign currency, reduce fragility.
Sudden stop prevention: CFMs during boom periods limit the buildup of short-term external debt that creates sudden stop vulnerability during reversals.
Global financial cycle insulation: in the presence of the global financial cycle [Ch. 32], CFMs can provide partial insulation from U.S. monetary policy spillovers that create undesirable domestic financial conditions.
The limits of CFMs are equally important: they are prone to circumvention as financial innovation creates new channels; they can reduce financial depth and deter long-term FDI; and they may provide cover for fiscal irresponsibility. The optimal CFM policy is temporary — applied during the exceptional period of dangerous inflow surge and removed once the vulnerability has been reduced — not a permanent structural feature.
35.5 IMF Conditionality and Structural Adjustment¶
When EMEs face balance-of-payments crises, they typically access IMF emergency financing in exchange for conditionality: policy commitments designed to restore external sustainability.
Definition (IMF Conditionality). Conditionality refers to the policy conditions attached to IMF lending: typically fiscal consolidation (reducing the primary deficit), monetary tightening (raising interest rates), exchange rate adjustment (devaluation), and structural reforms (liberalization, deregulation, privatization).
The Evidence on Conditionality¶
The empirical record is mixed. Latin American structural adjustment programs in the 1980s–90s were followed by the “lost decade” of slow growth and rising inequality; Sub-Saharan African adjustment programs were similarly disappointing. But the counterfactual is unclear — countries in crisis may have performed even worse without IMF resources and the policy discipline the program commitment imposes.
Several design features affect program effectiveness. Program ownership — whether the government genuinely supports the reforms versus implementing them under duress — is the strongest predictor of successful implementation and durable results. Structural conditionality (requirements for specific legislative or regulatory changes) has the weakest track record; quantitative conditionality (numerical fiscal and monetary targets) has stronger track record for short-run stabilization.
The IMF has substantially evolved its approach since the 1990s crisis experience. The 2012 World Economic Outlook explicitly recognized that fiscal multipliers in weak-growth environments were larger than assumed (Blanchard and Leigh, 2013), leading to less aggressive fiscal conditionality in programs. The pandemic response (2020–21) marked a further evolution: the IMF rapidly provided concessional financing to many low-income countries with minimal conditionality, recognizing that crisis conditions are not appropriate for structural reform implementation.
35.6 Monetary Policy Frameworks for Emerging Economies¶
Inflation targeting with managed float has become the dominant framework for middle-income EMEs: Brazil (1999), Mexico (2001), Chile (1999), Colombia (1999), South Africa (2000), South Korea (1998), Indonesia (2000). By 2020, approximately 40 EMEs were operating some form of inflation targeting. The framework provides a nominal anchor (the inflation target) while preserving exchange rate flexibility to absorb external shocks — superior to the full fixed exchange rate regimes that generated the currency crises of the 1990s [Ch. 32].
EME inflation targeting faces specific challenges absent in advanced economies: the higher ERPT means that exchange rate volatility threatens the inflation target, creating pressure for FX intervention that can conflict with the flexible exchange rate commitment; commodity price volatility creates large supply shocks that generate difficult trade-offs between stabilizing headline inflation and the output gap; and the lower institutional credibility means that an ambitious disinflation target missed repeatedly destroys credibility faster than a more modest target consistently met.
The Integrated Policy Framework (IPF) (IMF, 2021) represents the current state of the art: it acknowledges that in EMEs, monetary policy, exchange rate policy (FX intervention), macroprudential policy, and CFMs are complementary tools deployed simultaneously in response to external shocks, not substitutes between which a binary choice must be made. The optimal response to a sudden stop — for example — may involve all four simultaneously: interest rate adjustment (but less than under pure IT), FX intervention (reducing exchange rate volatility), macroprudential easing (supporting bank credit), and temporary CFMs (slowing capital outflows). The challenge for the IPF is providing clear operational guidance when to deploy each tool — a problem that remains an active area of policy development.
Chapter Summary¶
Original sin (Eichengreen and Hausmann) — the inability to borrow internationally in domestic currency — creates contractionary depreciation dynamics absent in reserve currency countries. Mitigation strategies: local currency bond market development, reserve accumulation, and hard pegs — each with different tradeoffs between credibility and flexibility.
High ERPT (0.3–0.5 vs. 0.05–0.1 in advanced economies) motivates exchange rate stabilization even under nominal IT, creating “fear of floating” (Calvo and Reinhart). The extended Taylor rule includes an exchange rate term ; credibility deficits raise the sacrifice ratio for disinflation by reducing the forward-looking NKPC component.
Fiscal dominance — monetization of deficits forced by limited alternative financing — implies that monetary stabilization requires simultaneous fiscal consolidation (Sargent-Wallace Unpleasant Arithmetic; fiscal theory of the price level). Monetary tightening alone defers rather than eliminates inflation.
Capital flow management tools are appropriate when inflows generate financial stability risks, amplify original sin vulnerabilities, create sudden stop exposure, or transmit unwanted global financial cycle shocks — but only temporarily, with mandatory removal once the exceptional circumstance passes.
IMF conditionality has mixed empirical track record; program ownership is the strongest predictor of success. The IMF has evolved toward lower multiplier assumptions, less structural conditionality, and more rapid concessional financing.
The Integrated Policy Framework (IMF, 2021) recognizes monetary, FX, macroprudential, and CFM tools as complements requiring simultaneous deployment — not substitutes between which a binary choice must be made.
Next: Chapter 36 — The Digital Economy: Technology, Productivity, and Employment