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Simple Monetary Policy Rules for Developing Countries

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  • Juan Pablo Medina
  • Ruy Lama

Abstract

This paper evaluates the performance of simple monetary policy rules in a calibrated model for the Chilean economy. The monetary regimes considered are: exchange rate peg, money peg, inflation targeting, nontradable inflation targeting, and a Taylor rule. We develop a small open economy model with tradable and nontradable goods, monopolistic competition and staggered prices á la Calvo. Business cycles fluctuations in the economy are driven by three types of shocks: foreign interest rate, productivity, and government expenditure. In this environment, the role of monetary policy is to offset as much as possible the distortions in the economy, namely staggered prices and monopolistic competition. We ranked the rules according to their ablity to smooth consumption and leisure of the representative household. The welfare analysis suggests that, depending on the source of the shock, it is optimal to stabilize either the price of the tradable goods or the nontradable goods. Rules with these targets are welfare superior to other monetary regimes, such as CPI inflation targeting or money peg. Our analysis tend to support some exchange rate intervention in order to achieve an efficient allocation of resources.

Suggested Citation

  • Juan Pablo Medina & Ruy Lama, 2004. "Simple Monetary Policy Rules for Developing Countries," Econometric Society 2004 Latin American Meetings 248, Econometric Society.
  • Handle: RePEc:ecm:latm04:248
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    References listed on IDEAS

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    1. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," Journal of Political Economy, University of Chicago Press, vol. 103(3), pages 624-660, June.
    2. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 2000. "Sticky Price Models of the Business Cycle: Can the Contract Multiplier Solve the Persistence Problem?," Econometrica, Econometric Society, vol. 68(5), pages 1151-1180, September.
    3. Jordi Galí & Tommaso Monacelli, 2005. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 707-734.
    4. McCallum, Bennett T. & Nelson, Edward, 1999. "Nominal income targeting in an open-economy optimizing model," Journal of Monetary Economics, Elsevier, vol. 43(3), pages 553-578, June.
    5. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2004. "Balance Sheets and Exchange Rate Policy," American Economic Review, American Economic Association, vol. 94(4), pages 1183-1193, September.
    6. 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.
    7. Sergio Rebelo & Carlos A. Vegh, 1995. "Real Effects of Exchange-Rate-Based Stabilization: An Analysis of Competing Theories," NBER Chapters,in: NBER Macroeconomics Annual 1995, Volume 10, pages 125-188 National Bureau of Economic Research, Inc.
    8. Reinhart, Carmen M. & Vegh, Carlos A., 1995. "Nominal interest rates, consumption booms, and lack of credibility: A quantitative examination," Journal of Development Economics, Elsevier, vol. 46(2), pages 357-378, April.
    9. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Stabilization policy and the costs of dollarization," Proceedings, Federal Reserve Bank of Cleveland, pages 482-517.
    10. Woodford Michael, 2002. "Inflation Stabilization and Welfare," The B.E. Journal of Macroeconomics, De Gruyter, vol. 2(1), pages 1-53, February.
    11. Cristina Arellano, 2005. "Default Risk, the Real Exchange Rate and Income Fluctuations in Emerging Economies," 2005 Meeting Papers 516, Society for Economic Dynamics.
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    More about this item

    Keywords

    Monetary Policy; Nontradable goods; Welfare Costs; Staggered Prices; Small Open Economy;

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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