A monetary approach to the exchange market pressure index under capital control

Abstract

The conventional Exchange Market Pressure Index (EMPI), originated from Girton and Roper (1977) and popularized by Eichengreen et al. (1994, 1995) and Weymark (1995), uses weighted average of loss of foreign reserves and depreciation of local currency to capture foreign exchange market pressure. However, it does not take into account the effect of capital control on foreign exchange market pressure. With effective capital control, the conventional EMPI tends to under- or overestimate the actual foreign exchange market pressure, depending on the magnitude of capital control. We adopt a monetary approach to derive a formula for new EMPI under capital control. Then we test the difference between the old and the new EMPI with China's data. The result shows that the conventional EMPI overestimates the actual foreign exchange market pressure by 91% in average.

Keywords:

• exchange market pressure
• capital control
• monetary model

JEL Classification:

• F31
• F32
• G15

Acknowledgements

Excellent research assistance by Zhongyuan Yuan and Shuzhan Zhou is greatly appreciated. The author would like to thank Thomas Willett, Barry Eichengreen, Ramkishen Rajan, Alice Ouyang and Liqing Zhang for sharing their insights. The author is also grateful for the comments from the participants of the fifth and sixth annual conferences of Asia–Pacific Economic Association, and the 84th annual conference of Western Economic Association. Financial supports from Ministry of Education, China (07JC90005), China National Social Science Fund (11CJL037) and CUFE Young Scholar Innovation Team Fund are greatly acknowledged. All errors remain the author's.

Notes

¹ Another large strand of the literature focuses on the relationship between the authority reaction and exchange market pressure; see Aizenman and Hutchison (2010) among others for different applications.

² Instead of the multiplicative form of right-hand side of Equation 5(5), some interpret it as risk premium using additive form. See Chinn and Meredith (2005) for applications.

³ The capital control index from Chinn and Ito (2008) is updated until year 2008.