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Overoptimism, Boom-Bust Cycles and Monetary Policy in Small Open Economies

Listed author(s):
  • Manuel Marfán L. .
  • Juan Pablo Medina G.
  • Claudio Soto G.

This paper analyzes boom-bust cycles in emerging market economies triggered by miss-perception about future productivity. Using a small open economy DSGE model we show that non-materialized news about future productivity improvements (i.e. overoptimism) generate boombust cycles that replicate the stylized facts of several emerging economies during the 1990s. We report simulation results for a boom-bust cycle under alternative monetary policy rules. In this context, we show that if the central bank tries to stabilize output, there would be a large real appreciation of the currency and a deep contraction in the tradable goods sector. When the central bank follows a more strict inflation targeting regime, the boom-bust pattern in major aggregate variables would be exacerbated. Finally, if the central bank attempts to sustain the real exchange rate, the perverse effects on the domestic tradable goods sector are only prevented in the short-run, but the boom-bust cycle in other variables is amplified.

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Article provided by Central Bank of Chile in its journal Economía Chilena.

Volume (Year): 11 (2008)
Issue (Month): 3 (December)
Pages: 81-104

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Handle: RePEc:chb:bcchec:v:11:y:2008:i:3:p:81-104
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  1. Beaudry, Paul & Portier, Franck, 2001. "An Exploration into Pigou's Theory of Cycles," CEPR Discussion Papers 2996, C.E.P.R. Discussion Papers.
  2. Aguiar, Mark & Gopinath, Gita, 2007. "Emerging Market Business Cycles: The Cycle is the Trend," Scholarly Articles 11988098, Harvard University Department of Economics.
  3. Beaudry, Paul & Portier, Franck, 2004. "When Can Changes in Expectations Cause Business Cycle Fluctuations in Neo-Classical Settings?," IDEI Working Papers 304, Institut d'Économie Industrielle (IDEI), Toulouse.
  4. Schmitt-Grohé, Stephanie & Uribe, Martín, 2002. "Closing Small Open Economy Models," CEPR Discussion Papers 3096, C.E.P.R. Discussion Papers.
  5. Correia, Isabel & Neves, Joao C. & Rebelo, Sergio, 1995. "Business cycles in a small open economy," European Economic Review, Elsevier, vol. 39(6), pages 1089-1113, June.
  6. Pablo Neumeyer & Fabrizio Perri, 2004. "Business cycles in emerging economies: the role of interest rates," Staff Report 335, Federal Reserve Bank of Minneapolis.
  7. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Working Paper 0107, Federal Reserve Bank of Cleveland.
  8. Nir Jaimovich & Sergio Rebelo, 2007. "News and Business Cycles in Open Economies," NBER Working Papers 13444, National Bureau of Economic Research, Inc.
  9. Mark Aguiar & Gita Gopinath, 2004. "Emerging market business cycles: the cycle is the trend," Working Papers 04-4, Federal Reserve Bank of Boston.
  10. Christopher J. Erceg & Dale W. Henderson & Andrew T. Levin, 1999. "Optimal monetary policy with staggered wage and price contracts," International Finance Discussion Papers 640, Board of Governors of the Federal Reserve System (U.S.).
  11. Martin Uribe & Vivian Z. Yue, 2004. "Country spreads and emerging countries: who drives whom?," Proceedings, Federal Reserve Bank of San Francisco, issue Jun, pages -.
  12. Gale, D. & Chamley, C., 1992. "Information Revelation and Strategic Delay in a Model of Investment," Papers 10, Boston University - Department of Economics.
  13. Jaimovich, Nir & Rebelo, Sérgio, 2006. "Can News About the Future Drive the Business Cycle?," CEPR Discussion Papers 5877, C.E.P.R. Discussion Papers.
  14. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  15. Abhijit V. Banerjee, 1992. "A Simple Model of Herd Behavior," The Quarterly Journal of Economics, Oxford University Press, vol. 107(3), pages 797-817.
  16. Roger E. A. Farmer, 1999. "Macroeconomics of Self-fulfilling Prophecies, 2nd Edition," MIT Press Books, The MIT Press, edition 2, volume 1, number 0262062038, December.
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