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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 firms 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 effect 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 effectiveness of conventional macroeconomic policies when applied to low-income countries.

Suggested Citation

  • SENBETA, Sisay Regassa, 2013. "Foreign exchange constraints and macroeconomic dynamics in a small open economy," Working Papers 2013023, University of Antwerp, Faculty of Applied Economics.
  • Handle: RePEc:ant:wpaper:2013023
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    More about this item

    Keywords

    New Keynesian DSGE; Foreign exchange constraint; Low income countries; Ethiopia;

    JEL classification:

    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • F31 - International Economics - - International Finance - - - Foreign Exchange
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • O55 - Economic Development, Innovation, Technological Change, and Growth - - Economywide Country Studies - - - Africa

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