Evidence on the sectoral monetary transmission process under a fixed exchange rate regime

Traditional macroeconomic models suggest that monetary policy changes are largely ineffective in fixed exchange rate economies. However, Edwards and Vegh (1997) present a model that shows this might not be the case, as a tightening in monetary policy raises financial costs faced by firms and therefore lowers real wages and, by extension, consumption. This paper empirically tests this hypothesis using data on a country with one of the longest running fixed exchange rate regimes (1975-present). The results of the study confirm the theoretical predictions of Edwards and Vegh, but they also show that the propagation of nominal shocks in fixed exchange rate systems is comparatively slower than in countries with a more flexible exchange rate regime.