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Procyclical Monetary Policy And Governance

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Executive Summary

Weak governance adversely affects firm's net worth and consequently the value of its collateral. This negative impact on the collateral reduces the external credit available for importing inputs constraining potential output. As a result, a stronger procyclical monetary policy stance is adopted for protecting the exchange rate and hence arresting the degradation in the collateral constraint. The existence of a procyclical monetary policy in emerging economies is at odds with that of the developed world. Amongst other reasons, a large literature (Ag?nor and Montiel (2010) and Frankel (2010)) explains this odd feature by focusing on the theme of the impact of currency depreciation on the revaluation of debt and the ability to raise future external financing.

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