# **I. Introduction**

Monetary policy transmission in emerging market economies (EMEs) is confounded by the puzzling behavior of prices and exchange rates in response to changes in policy interest rates. Evidence that monetary policy tightening leads to an increase in prices has been characterized as a “price puzzle.” In a survey of 70 studies spanning 31 countries, Rusnák et al. (2013) find that half of the studies find evidence of the price puzzle. Country-specific studies have confirmed the existence of this puzzle. Another curious empirical feature in many EMEs is that monetary policy tightening leads to domestic currency depreciation ( _foreign exchange rate puzzle or FX puzzle_ ) or gradual appreciation over a prolonged period ( _delayed overshooting)_ .<sup>2</sup> These empirical puzzles may partly reflect the complications EME central banks face in stabilizing business and financial cycles. The channels through which monetary policy influences economic activity and financial markets—including interest rates, exchange rates, asset prices, and credit (and bank lending)—appear not to operate properly in EMEs due to the incompleteness of and imperfections in financial markets or due to the procyclical nature of monetary policy.<sup>3</sup> Alternatively, standard empirical models may fail to capture the true effects of monetary policy shocks because macroeconomic and financial variables in EMEs are highly volatile.

In the case of advanced economies, an appealing explanation for the price puzzle is that their central banks have more information about future inflation than can be captured by a simple VAR model (Sims 1992; Grilli and Roubini 1996). This omission implies that a policy tightening in anticipation of a jump in future inflation would be misinterpreted in conventional models as a policy shock. If monetary policy only partially offsets inflationary pressures, such models would deliver a spurious positive correlation between policy rates and inflation.<sup>4</sup> Prior resolutions of the price puzzle have focused largely on advanced economies (e.g., Barth and Ramey 2002; Blanchard 2004; Rabanal 2007; Castelnuovo and Surico 2010). A few studies have looked at individual EMEs and generally find mixed results (Minella 2003; Cysne 2004; Luporini 2008; Céspedes et al. 2008; Carvalho and Rossi Júnior 2009; Kohlscheen 2014; Costa Filho 2017).<sup>5</sup> The main contribution of our paper is to systematically assess the ability of those proposed solutions to resolve the puzzles within a unified framework for a set of EMEs. We find that incorporating forward-looking expectations into the model helps to simultaneously resolve the

> 2 Using a meta-analysis, for instance, Hnatkovska et al. (2012, 2016) find that the exchange rate depreciates in response to positive shocks to the interest rate differential in 37 out of 49 developing countries.

> 3 See Hammond et al. (2009), Frankel (2010), Mishra et al. (2012), and De Leo et al. (2023).

> 4 Other explanations of the price puzzle include: cost-push channel of monetary policy transmission (Barth and Ramey 2002; Rabanal 2007), currency depreciation and its pass-through to inflation (Blanchard 2004) or Indeterminacy—passive monetary policies by central banks (Castelnuovo and Surico 2010). More detailed theoretical discussions of the price puzzle and the literature review are provided in Appendix II.

> 5 Some recent papers, such as Choi et al. (2024) and Deb et al. (2023), have attempted to better identify exogenous monetary policy shocks for EMEs and have provided evidence of monetary policy transmission without encountering the price puzzle. By contrast, we explore various approaches proposed in the literature and examine cross-country evidence alongside country-specific analyses. Additionally, we address both the price and FX puzzles simultaneously.

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