Alternative Monetary-Policy Instruments and Limited Credibility in Small and Open Economies: An Exploration

We evaluate the dynamics of a small and open economy under alternative monetary policy instruments, in a model with imperfectly anchored expectations. The consensus under inflation targeting is that rules for an interest rate are preferred, instead of using either some monetary aggregate or the exchange rate. Theses arguments are usually presented assuming rational expectations (RE) hold and there is full credibility. In contrast we consider deviations from RE, where a fraction of agents uses econometric models to form expectations, capturing imperfectly anchored expectations or limited credibility (LC). The model also features a non-trivial banking sector, allowing for different interest rates and monetary aggregates. We compare the dynamics after a shock to the cost of external borrowing (arguably one of the most important sources of fluctuations in emerging countries) under three policy instruments: a Taylor-type rule for the interest rate, a constant-growth-rate rule for base money, and a fixed exchange rate. The analysis allows to identify relevant trade-offs in choosing alternative policy instruments, showing that the differences between the alternatives are exacerbated under LC.