Monetary Policy Rules in a Small Open Economy: An Application to Mexico

We estimate a small-scale macro model for the Mexican economy under the New Keynesian framework. We then estimate alternative interest rate rules for Mexico, and use the results from both exercises to evaluate the performance of the Bank of Mexico against a set of optimality principles derived in the New Keynesian literature. We show that the Bank of Mexico holds a preference for stabilizing not only inflation around target, but also acts to achieve an output gap close to zero. Furthermore, we show the central bank responds non-linearly to real exchange rate depreciations. We also show that, although the central bank has attempted to contain inflation, it has not conclusively satisfied the Taylor principle, so moderate inflation during the period may be partly a consequence of a favorable macroeconomic environment, rather than active policy.