The International Monetary Fund has published a Staff Discussion Note presenting an empirical toolkit to help policymakers in emerging markets and developing economies distinguish exchange rate movements caused by financial shocks and impaired market functioning from those reflecting macroeconomic fundamentals. The distinction informs the IMF’s Integrated Policy Framework because exchange rates should generally adjust to fundamental shocks, while foreign exchange intervention may be appropriate when financial frictions generate destabilizing currency risk premia. Using 15 years of monthly data from 25 economies, the framework combines uncovered interest parity premia with macrofinancial indicators, model based sign restrictions and evidence from documented stress episodes. Applications to Chile and Brazil indicate that financial shocks account for around one-third of fluctuations in uncovered interest parity premia and a larger share of exchange rate variation, but these episodes can coincide with sharp output contractions. The toolkit can also incorporate timely indicators such as exchange rates and bid ask spreads for real time assessment, although it does not provide a mechanical intervention rule. Evidence of a financial shock is not sufficient by itself to justify intervention. Policymakers must also assess reserve adequacy, intervention effectiveness, shock persistence, policy consistency, costs and the availability of other instruments, while preserving exchange rate flexibility where needed for macroeconomic adjustment.

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