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Monetary and Fiscal Rules in an Emerging Small Open Economy

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  • Paul Levine
  • Joseph Pearlman
  • Nicoletta Batini

Abstract

We develop a optimal rules-based interpretation of the ''three pillars macroeconomic policy framework'': a combination of a freely floating exchange rate, an explicit target for inflation, and a mechanism than ensures a stable government debt-GDP ratio around a specified long run. We show how such monetary-fiscal rules need to be adjusted to accommodate specific features of emerging market economies. The model takes the form of two-blocs, a DSGE emerging small open economy interacting with the rest of the world and features, in particular, financial frictions It is calibrated using Chile and US data. Alongside the optimal Ramsey policy benchmark, we model the three pillars as simple monetary and fiscal rules including and both domestic and CPI inflation targeting interest rate rules alongside a ''Structural Surplus Fiscal Rule'' as followed recently in Chile. A comparison with a fixed exchange rate regime is made. We find that domestic inflation targeting is superior to partially or implicitly (through a CPI inflation target) or fully attempting to stabilizing the exchange rate. Financial frictions require fiscal policy to play a bigger role and lead to an increase in the costs associated with simple rules as opposed to the fully optimal policy.

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Bibliographic Info

Paper provided by International Monetary Fund in its series IMF Working Papers with number 09/22.

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Length: 78
Date of creation: 01 Jan 2009
Date of revision:
Handle: RePEc:imf:imfwpa:09/22

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Keywords: Emerging markets; External shocks; Economic models; inflation; fiscal policy; monetary policy; fiscal rule; nominal interest rate; foreign currency; inflation targeting; government spending; fiscal surplus; tax rates; inflation rate; fiscal rules; fiscal stabilization; government budget; budget constraint; structural fiscal; monetary economics; terms of trade; budget constraints; fiscal instrument; nominal interest rates; inflation target; government budget constraint; real interest rate; real money; rational expectations; taxation; fiscal authority; fiscal instruments; fiscal policy rules; fiscal surpluses; relative price; fiscal expansion; government budget constraints; inflation rates; fiscal plan; tax changes; fiscal stability; tax revenues; fiscal revenues; real variables; fiscal policy prescriptions; fiscal planning; fiscal authorities; expansionary fiscal; money stock; price inflation; tax income; money supply; fiscal spending; macroeconomic analysis; government spending shocks; cyclical fiscal policy; real interest rates; government expenditure; fiscal deficit; steady-state inflation; fiscal shocks;

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References

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  1. Adam, Klaus & Billi, Roberto M., 2005. "Discretionary monetary policy and the zero lower bound on nominal interest rates," CFS Working Paper Series 2005/16, Center for Financial Studies (CFS).
  2. Pierpaolo Benigno, 2008. "Price stability with imperfect financial integration," Proceedings, Board of Governors of the Federal Reserve System (U.S.), Board of Governors of the Federal Reserve System (U.S.).
  3. Nicoletta Batini & Stephen P. Millard & Richard Harrison, 2000. "Monetary Policy Rules For An Open Economy," Computing in Economics and Finance 2000, Society for Computational Economics 361, Society for Computational Economics.
  4. Coenen, Gunter & Wieland, Volker, 2003. "The zero-interest-rate bound and the role of the exchange rate for monetary policy in Japan," Journal of Monetary Economics, Elsevier, Elsevier, vol. 50(5), pages 1071-1101, July.
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  8. Nicoletta Batini & Paul Levine & Joseph Pearlman, 2007. "Monetary Rules in Emerging Economies with Financial Market Imperfections," School of Economics Discussion Papers, School of Economics, University of Surrey 0807, School of Economics, University of Surrey.
  9. Benigno, Gianluca & Benigno, Pierpaolo, 2008. "Exchange rate determination under interest rate rules," Journal of International Money and Finance, Elsevier, Elsevier, vol. 27(6), pages 971-993, October.
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  11. Andrew T. Levin & Alexei Onatski & John Williams & Noah M. Williams, 2006. "Monetary Policy Under Uncertainty in Micro-Founded Macroeconometric Models," NBER Chapters, National Bureau of Economic Research, Inc, in: NBER Macroeconomics Annual 2005, Volume 20, pages 229-312 National Bureau of Economic Research, Inc.
  12. Chadha, J.S. & Charles Nolan, 2002. "Optimal Simple Rules for the Conduct of Monetary and Fiscal Policy," Cambridge Working Papers in Economics, Faculty of Economics, University of Cambridge 0224, Faculty of Economics, University of Cambridge.
  13. Currie,David & Levine,Paul, 1993. "Rules, Reputation and Macroeconomic Policy Coordination," Cambridge Books, Cambridge University Press, Cambridge University Press, number 9780521441964.
  14. Levine, Paul & McAdam, Peter & Pearlman, Joseph G., 2007. "Quantifying and sustaining welfare gains from monetary commitment," Working Paper Series, European Central Bank 0709, European Central Bank.
  15. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2004. "Balance Sheets and Exchange Rate Policy," American Economic Review, American Economic Association, American Economic Association, vol. 94(4), pages 1183-1193, September.
  16. Aoki, Kosuke & Kimura, Takeshi, 2007. "Uncertainty about perceived inflation target and monetary policy," Discussion Paper Series 1: Economic Studies 2007,18, Deutsche Bundesbank, Research Centre.
  17. Paul Levine & Joseph Pearlman & Richard Pierse, 2006. "Linear-Quadratic Approximation, Efficiency and Target-Implementability," Computing in Economics and Finance 2006, Society for Computational Economics 441, Society for Computational Economics.
  18. Tatiana Kirsanova & Simon Wren-Lewis, 2006. " Optimal Fiscal Feedback on Debt in an Economy with Nominal Rigidities," CDMA Conference Paper Series, Centre for Dynamic Macroeconomic Analysis 0609, Centre for Dynamic Macroeconomic Analysis.
  19. Levine, Paul & Currie, David, 1987. "The design of feedback rules in linear stochastic rational expectations models," Journal of Economic Dynamics and Control, Elsevier, Elsevier, vol. 11(1), pages 1-28, March.
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Citations

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Cited by:
  1. Eric M. Leeper, 2009. "Anchors Away: How Fiscal Policy Can Undermine “Good” Monetary Policy," Caepr Working Papers, Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington 2009-021, Center for Applied Economics and Policy Research, Economics Department, Indiana University Bloomington.
  2. Nicoletta Batini & Vasco J. Gabriel & Paul Levine & Joseph Pearlman, 2010. "A Floating versus Managed Exchange Rate Regime in a DSGE Model of India," NIPE Working Papers, NIPE - Universidade do Minho 31/2010, NIPE - Universidade do Minho.
  3. Vasco Gabriel & Paul Levine & Joseph Pearlman & Bo Yang, 2010. "An Estimated DSGE Model of the Indian Economy," School of Economics Discussion Papers, School of Economics, University of Surrey 1210, School of Economics, University of Surrey.
  4. Nicoletta Batini & Paul Levine & Emanuela Lotti & Bo Yang, 2011. "Informality, Frictions and Monetary Policy," School of Economics Discussion Papers, School of Economics, University of Surrey 0711, School of Economics, University of Surrey.
  5. Eduardo Engel & Christopher Neilson & Rodrigo Valdés, 2011. "Chile’s Fiscal Rule as Social Insurance," Working Papers Central Bank of Chile, Central Bank of Chile 627, Central Bank of Chile.
  6. Fredj Jawadi & Sushanta K. Mallick & Ricardo M. Sousa, 2011. "Monetary Policy Rules in the BRICS: How Important is Nonlinearity?," NIPE Working Papers, NIPE - Universidade do Minho 18/2011, NIPE - Universidade do Minho.
  7. Paul Levine, 2012. "Policy focus: Monetary policy in an uncertain world: probability models and the design of robust monetary rules," Indian Growth and Development Review, Emerald Group Publishing, Emerald Group Publishing, vol. 5(1), pages 70-88, April.
  8. Eric M. Leeper, 2009. "Anchors Away: How Fiscal Policy Can Undermine the Taylor Principle," NBER Working Papers 15514, National Bureau of Economic Research, Inc.
  9. Batini, Nicoletta & Levine, Paul & Lotti, Emanuela & Yang, Bo, 2011. "Monetary and Fiscal Policy in the Presence of Informal Labour Markets," Working Papers, National Institute of Public Finance and Policy 11/97, National Institute of Public Finance and Policy.
  10. Magnus Saxegaard & Rahul Anand & Shanaka J. Peiris, 2010. "An Estimated Model with Macrofinancial Linkages for India," IMF Working Papers 10/21, International Monetary Fund.
  11. Agnès Bénassy-Quéré & Véronique Salins, 2010. "A Case for Intermediate Exchange-Rate Regimes," Working Papers 2010-14, CEPII research center.
  12. Robert Ambrisko & Jan Babecky & Jakub Rysanek & Vilem Valenta, 2012. "Assessing the Impact of Fiscal Measures on the Czech Economy," Working Papers, Czech National Bank, Research Department 2012/15, Czech National Bank, Research Department.
  13. Apostolis Philippopoulos & Petros Varthalitis & Vanghelis Vassilatos, 2012. "On the optimal mix of fiscal and monetary policy actions," Working Papers, Bank of Greece 150, Bank of Greece.
  14. Eric M. Leeper, 2011. "Anchors Aweigh: How Fiscal Policy Can Undermine “Good” Monetary Policy," Central Banking, Analysis, and Economic Policies Book Series, Central Bank of Chile, in: Luis Felipe Céspedes & Roberto Chang & Diego Saravia (ed.), Monetary Policy under Financial Turbulence, edition 1, volume 16, chapter 11, pages 411-453 Central Bank of Chile.

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