Financial Vulnerability and Stabilization Policy in Commodity Exporting Emerging Economies

This paper develops a new Keynesian DSGE model compatible with the structural characteristics of commodity exporting developing economies (financial vulnerability, relatively high pass-through rates, procyclical fiscal policy, and high terms of trade volatility) to compare the performance of alternative policy regimes, namely flexible domestic inflation targeting, flexible consumer price index inflation targeting, and the real exchange rate targeting. Evaluation of the above alternative policy regimes and relative stability of key macroeconomic variables are conducted through an optimal Ramsey policy method. The policy evaluation results based both on stabilization and welfare measures obtained for the case of Iran imply that for the developing commodity (oil) exporting economies stabilization with a broader inflation targeting framework in which the real exchange rate is also targeted is the superior policy regime. Optimality of the alternative policy regimes and their rank are sensitive to the degree of financial vulnerability. Financial vulnerability in this model explains why departure from floating exchange rate in an inflation targeting framework is the appropriate policy and not merely a “fear”. As the degree of financial development increases sufficiently, the standard flexible inflation targeting becomes the superior policy regime. A policy rule to weaken procyclicality of fiscal policy further enhances the welfare performance of this regime.