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The Natural Interest Rate in Emerging Markets

  • Ashima Goyal

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An optimizing model of a small open emerging market economy (SOEME) with dualistic labour markets and two types of consumers, is used to derive the natural interest rate, terms of trade and potential output. Shocks are classified into generic types that affect the natural interest rates. Since parameters depend on features of the labour market and on consumption inequality, the natural rates and the impact of shocks differ from those in a mature small open economy. Subsistence consumption is found to have the largest effect on the natural rates. It reduces the interest rate, raises natural output and the terms of trade. Technology and infrastructure backwardness reduce natural output. The implications for monetary policy are derived. The effect of managed exchange rates combined with different types of inflation targeting is examined through simulations. Endogenous terms of trade make the supply curve steeper in a SOEME, so partial stickiness of the real exchange rate can be beneficial. In general, domestic inflation targeting, with some weight on the output gap, delivers lower volatility. Output response is higher and volatility lower with fixed terms of trade, demonstrating the flatter supply curve. CPI inflation targeting also does well when terms of trade are credibly fixed.

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Paper provided by eSocialSciences in its series Working Papers with number id:1675.

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Date of creation: Sep 2008
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Handle: RePEc:ess:wpaper:id:1675
Note: Institutional Papers
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  1. Richard Clarida & Jordi Gali & Mark Gertler, 2001. "Optimal Monetary Policy in Closed versus Open Economies: An Integrated Approach," NBER Working Papers 8604, National Bureau of Economic Research, Inc.
  2. Reinhart, Carmen & Ogaki, Masao & Ostry, Jonathan, 1996. "Saving Behavior in Low- and Middle-Income Developing Countries: A Comparison," MPRA Paper 6978, University Library of Munich, Germany.
  3. Ashima Goyal, 2006. "Incentives from exchange rate regimes in an institutional context," Indira Gandhi Institute of Development Research, Mumbai Working Papers 2006-015r, Indira Gandhi Institute of Development Research, Mumbai, India.
  4. Arminio Fraga & Ilan Goldfajn & Andre Minella, 2003. "Inflation Targeting in Emerging Market Economies," NBER Working Papers 10019, National Bureau of Economic Research, Inc.
  5. Robert E. Hall & Charles I. Jones, 1999. "Why Do Some Countries Produce So Much More Output Per Worker Than Others?," The Quarterly Journal of Economics, MIT Press, vol. 114(1), pages 83-116, February.
  6. Richard Clarida & Jordi Gali & Mark Gertler, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," NBER Working Papers 7147, National Bureau of Economic Research, Inc.
  7. Goyal, Ashima, 2011. "A general equilibrium open economy model for emerging markets: Monetary policy with a dualistic labor market," Economic Modelling, Elsevier, vol. 28(3), pages 1392-1404, May.
  8. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1997. "Monetary policy shocks: what have we learned and to what end?," Working Paper Series, Macroeconomic Issues WP-97-18, Federal Reserve Bank of Chicago.
  9. Goyal, Ashima & Dash, Shridhar, 2000. "The Money Supply Process in India: Identification, Analysis and Estimation," MPRA Paper 24632, University Library of Munich, Germany.
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