Monetary policy rules for financially vulnerable economies
Section snippets
Motivation
One offspring of the recent, yet recurring debate on the optimal exchange rate regime for emerging market economies is the so-called hollowing-out hypothesis.1 According to this, the
An overview of monetary policy in Latin America
The long-term quest for one digit inflation is about to become a reality for all Latin American countries. After three decades of high inflation the region has come back on track and the downward trend on inflation looks very promising (see Fig. 1).19
A small open economy model
Based on the previous work of Ball (1999), Leitemo (1999), and specially Svensson (2000) on open economies, we propose a small, open-economy model that will help us to derive quantitative results about the transmission mechanisms that underlie a liability-dollarized economy and to discuss the policy options in such an economy. The model is a standard forward-looking, rational-expectations model, in which the monetary authority has a flexible exchange rate regime and cares about inflation and
Model parameterization
The model has to be solved numerically as the solution could not be characterized analytically. We calibrate the parameters of the model with estimates from four different countries. In Appendix Table 1 we show the results of those estimations for Australia, New Zealand, Perú, and Uruguay. On the one hand, we used Australia and New Zealand as a benchmark for a financially robust economy. On the other hand, we considered Perú and Uruguay estimates to parameterize the financially vulnerable
Model solution and simulations
In this section we present three exercises in order to answer the question of which is the best way to conduct an IT regime conditional on the economy type. First of all, we compute the optimal policy rule without restrictions on the set of policy indicators. Then, we restrict our attention to fixed rules in which a much narrow set of indicators is used to guide monetary policy. Instead of calibrate the parameters associated with those rules we compute optimized coefficients for each rule.
Conclusion
This paper has been written from the perspective of the central bank that chooses to adopt an IT regime within a very special set of initial conditions: an emergent economy with highly dollarized liabilities. Therefore, we have addressed the issue assuming that the Central Bank has chosen to “walk the talk” and we explore the optimal way to do that within a simple small, open-economy model that captures the striking characteristics of the economy. For that purpose, we compare the optimality of
Acknowledgement
This paper was written while Eduardo Morón was a Visiting Scholar in the Research Department of the International Monetary Fund. This paper has benefited from conversations with staff at the IMF, the Macro Discussion Group of Consorcio de Investigación Económica y Social and seminar participants at LACEA 2001, Central Bank of Perú, SPEEA 2001, and Universidad del Pacifico. We would like to thank Norman Loayza, Mauricio Villafuerte and two anonymous referees for very useful comments. We are
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