1 Handbook of Development Economics (The E ffect of) Monetary and E xchange Rate Policies (on Development) Eduardo Levy Yeyati and Federico Sturzenegger 1 1. Introduction How to achieve stable, sustainable and equitable economic growth is the defining question in development economics. Unfortunately, a clear answer to this question have proven to be as elusive as the question is important, not the least because visually any decision that policy makers make can be argued to have an effect on at least some of the main development dimensions. Monetary and exchange rate policies (ME RP), the subject of this chapter, are no exception to this rule. B ecause they determine, to a great extent, the macroeconomic environment in which the economy operates, its relevance for development appears to be quite natural. But the analytical economic literature has not been supportive of this connection: nominal variables are often seen as immaterial for the real economy in the long run. Moreover, even in the vast body of work that explores this link empirically, a multiplicity of country– specific channels that have been proposed –and usually examined separately–, which makes the task of deriving usable policy conclusions rather arduous. As we will argue below, the choice of ME RP not only has a direct implication on the evolution of key nominal variables of the economy (prices, the exchange rate) and, as a result, on inflation, output volatility, and the evolution of the financial sector –which, in turn, may have effects on policy objectives such as output growth and income distribution– but may also affect other variables that are somewhat unrelated to monetary issues: stable exchange rates may foster trade as well as financial vulnerability (as it undermines the incentives of agents to hedge against currency risk). Consider, for example, the adoption of the E uro, which was –at least officially– predicated on its potential trade gains rather than on the benefits of a monetary anchor; or the preference for non-pegged regimes induced by the need to elude the speculative currency attacks that the pegs often invite. 1 World Bank and Universidad Torcuato Di Tella, and Kennedy School of Government and Universidad Torcuato Di Tella, repectively.