Monetary and Fiscal Rules in an Emerging Small Open Economy

79 Pages Posted: 11 Mar 2009

See all articles by Nicoletta Batini

Nicoletta Batini

International Monetary Fund (IMF)

Paul Levine

School of Economics, University of Surrey

Joseph Pearlman

London Metropolitan University - Department of Economics, Finance and International Business (EFIB)

Date Written: February 2009

Abstract

We develop a optimal rules-based interpretation of the 'three pillars macroeconomic policy framework': a combination of a freely floating exchange rate, an explicit target for inflation, and a mechanism than ensures a stable government debt-GDP ratio around a specified long run. We show how such monetary-fiscal rules need to be adjusted to accommodate specific features of emerging market economies. The model takes the form of two-blocs, a DSGE emerging small open economy interacting with the rest of the world and features, in particular, financial frictions It is calibrated using Chile and US data. Alongside the optimal Ramsey policy benchmark, we model the three pillars as simple monetary and fiscal rules including and both domestic and CPI inflation targeting interest rate rules alongside a 'Structural Surplus Fiscal Rule' as followed recently in Chile. A comparison with a fixed exchange rate regime is made. We find that domestic inflation targeting is superior to partially or implicitly (through a CPI inflation target) or fully attempting to stabilizing the exchange rate. Financial frictions require fiscal policy to play a bigger role and lead to an increase in the costs associated with simple rules as opposed to the fully optimal policy.

Keywords: Emerging markets, External shocks, Monetary policy, Interest rate policy, Fiscal policy, Economic models

Suggested Citation

Batini, Nicoletta and Levine, Paul L. and Pearlman, Joseph G., Monetary and Fiscal Rules in an Emerging Small Open Economy (February 2009). IMF Working Papers, Vol. , pp. 1-78, 2009. Available at SSRN: https://ssrn.com/abstract=1356450

Nicoletta Batini

International Monetary Fund (IMF) ( email )

700 19th Street NW
Washington, DC 20431
United States

Paul L. Levine

School of Economics, University of Surrey ( email )

Guildford
Surrey GU2 7XH
United Kingdom
+44 1483 259 380 Ext. 2773 (Phone)
+44 1483 259 548 (Fax)

Joseph G. Pearlman

London Metropolitan University - Department of Economics, Finance and International Business (EFIB) ( email )

Economics Subject Group, LMBS
London EC2M 6SQ, EC2M 6SQ
United Kingdom

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