Monetary policy rules for financially vulnerable economies

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Abstract

One distinguishable characteristic of emerging market economies is that they are not financially robust. These economies are incapable of smoothing out large external shocks, as sudden capital outflows imply abrupt swings in the real exchange rate. Using a small open-economy model, this paper examines alternative monetary policy rules for economies with different degrees of liability dollarization. The paper answers the question of how efficient it is to use inflation targeting (IT) under high liability dollarization. Our findings suggest that it might be optimal to follow a nonlinear policy rule that defends the real exchange rate in a financially vulnerable economy.

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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