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

  • 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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File URL: http://www.bcentral.cl/eng/studies/economia-chilena/2008/dec/Vol11N3dic2008pp81-104.pdf
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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. Aguiar, Mark & Gopinath, Gita, 2007. "Emerging Market Business Cycles: The Cycle is the Trend," Scholarly Articles 11988098, Harvard University Department of Economics.
  2. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 2001. "Nominal rigidities and the dynamic effects of a shock to monetary policy," Working Paper Series WP-01-08, Federal Reserve Bank of Chicago.
  3. Chamley, Christophe & Gale, Douglas, 1994. "Information Revelation and Strategic Delay in a Model of Investment," Econometrica, Econometric Society, vol. 62(5), pages 1065-85, September.
  4. 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.
  5. Erceg, Christopher J. & Henderson, Dale W. & Levin, Andrew T., 2000. "Optimal monetary policy with staggered wage and price contracts," Journal of Monetary Economics, Elsevier, vol. 46(2), pages 281-313, October.
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  7. Correia, Isabel & Neves, Joao C & Rebelo, Sérgio, 1994. "Business Cycles in a Small Open Economy," CEPR Discussion Papers 996, C.E.P.R. Discussion Papers.
  8. Beaudry, Paul & Portier, Franck, 2001. "An Exploration into Pigou's Theory of Cycles," CEPR Discussion Papers 2996, C.E.P.R. Discussion Papers.
  9. Stephanie Schmitt-Grohe & Martin Uribe, 2002. "Closing Small Open Economy Models," NBER Working Papers 9270, National Bureau of Economic Research, Inc.
  10. Pablo Andres Neumeyer & Fabrizio Perri, 1999. "Business Cycles in Emerging Economies: the role of interest rates," Department of Economics Working Papers 014, Universidad Torcuato Di Tella.
  11. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  12. Nir Jaimovich & Sergio Rebelo, 2006. "Can News About the Future Drive the Business Cycle?," 2006 Meeting Papers 31, Society for Economic Dynamics.
  13. Martin Uribe & Vivian Yue, 2004. "Country spreads and emerging countries: who drives whom?," Proceedings, Federal Reserve Bank of San Francisco, issue Jun.
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  15. Banerjee, Abhijit V, 1992. "A Simple Model of Herd Behavior," The Quarterly Journal of Economics, MIT Press, vol. 107(3), pages 797-817, August.
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