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Foreign exchange constraints and macroeconomic dynamics in a small open economy

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  • SENBETA, Sisay Regassa

Abstract

Firms in most low-income countries depend almost entirely on imported capital and intermediate inputs. As a result, the availability and cost of foreign exchange play a crucial role on the macroeconomic performance of these countries. In this study we introduce foreign exchange constraints that importing ?rms face and the foreign exchange reserve management problem of the central banks in such economies into a small open economy New Keynesian model. We calibrated the model to the Ethiopian economy. Our simulation experiments show that given the foreign exchange constraints and the standard monetary policy rule, contractionary monetary policy leads to expansion in output and consumption and contraction in employment. This e¤ect is more pronounced if the duration of price stickiness for the imported goods is short relative to that of the domestically produced goods which seems to be the case for countries like Ethiopia. This result, to the minimum, reminds us that one needs to be cautious about the e¤ectiveness of conventional macroeconomic policies when applied to low-income countries.

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Bibliographic Info

Paper provided by University of Antwerp, Faculty of Applied Economics in its series Working Papers with number 2013023.

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Length: 63 pages
Date of creation: Sep 2013
Date of revision:
Handle: RePEc:ant:wpaper:2013023

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Web page: https://www.uantwerp.be/en/faculties/applied-economic-sciences/
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Keywords: New Keynesian DSGE; Foreign exchange constraint; Low income countries; Ethiopia;

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