The World Bank Research Observer, vol. 18, no. 1 (Spring 2003), pp. 1–23 DOI: 10.1093/wbro/lkg001 © 2003 The International Bank for Reconstruction and Development / the world bank 1 Tight Money in a Post-Crisis Defense of the Exchange Rate: What Have We Learned? Peter J. Montiel Critics of the tight monetary policies pursued by some of the countries hurt by the 1997 Asian financial crisis have questioned the presumption that tight money can help sustain the value of a currency. The issue is actually an empirical one because theory does not un- ambiguously predict the effect of tight money on the exchange rate under the circumstances faced by the crisis countries. This article reviews the empirical research and shows that the evidence does not yet support strong statements about post-crisis links between monetary policy and the exchange rate. Proposed deviations from a sustainable medium-term mon- etary policy stance should thus be viewed with skepticism. The policy advice given by the imf during the 1997 Asian financial crisis has gener- ated much controversy. Several aspects of the imf’s policy advice have been called into question, but a main focus has been its advocacy of tight monetary policy in coun- tries experiencing recessions and banking crises. This policy prescription seems to run counter both to the standard countercyclical role that monetary policy plays during recessions in industrial countries and to the traditional role of the central bank as lender of last resort in a confidence-driven banking crisis. The imf originally advocated a tight-money policy stance to prevent exchange rate depreciation from being “passed through” excessively to domestic prices and to limit the “overshooting” of exchange rate depreciation, thereby mitigating the adverse effects of depreciation on the net worth of domestic financial institutions and firms (see Lane and others 1999). Because many firms and banks in the crisis countries had severe currency mismatches on their balance sheets, the imf feared that an excessive depreciation of the currency would exacerbate the danger to their solvency, thereby potentially magnifying the economic dislocations and output losses associated with the crisis.