Monetary rules in an open economy with distortionary subsidies and inefficient shocks: A DSGE approach for Bolivia

Through an estimated and calibrated DSGE model with imperfect competition and nominal rigidities, this work aims to assess the dynamic effects of exogenous perturbations in a small open economy to provide a prescription of a simple monetary policy rule associated with the minimal welfare losses in the case of Bolivia. Following Gali and Monacelli (2005) and De Paoli (2009), I display the baseline model in a canonical representation. Yet, unlike them, I consider the presence of efficient and inefficient perturbations, namely government spending, productivity, foreign demand, and cost-push shocks, to analyze its effects in terms of observable variables but also on the relevant output gap. Moreover, considering the significance of raw materials as a proportion of the Bolivian exports, I extend the model by taking into account a distortionary subsidy on consumption financed by the positive profits of the commodity sector, Further, in the style of Gali and Monacelli (2005), I compare the welfare implications under two scenarios: A monetary rule focus on maintain a nominal exchange rate peg (fixed) regime and a Taylor rule. The main results reveal that the latter outperforms the former when the full set of shocks occurs simultaneously, showing the importance of inflation targeting. Yet, by focusing only on inefficient exogenous perturbations, and taking into account a pegged regime and a simple Taylor rule based on consumer and producer price inflation, the ranking of monetary policy aligns in the first place an exchange rate peg. This scenario shows the potential success of alternative simple monetary rules under these circumstances.