Overoptimism, Boom-Bust Cycles and Monetary Policy in Small Open Economies

This paper analyzes boom-bust cycles in emerging market economies triggered by miss-perception about future productivity. Using a small open economy DSGE model we show that non-materialized news about future productivity improvements (i.e. overoptimism) generate boombust cycles that replicate the stylized facts of several emerging economies during the 1990s. We report simulation results for a boom-bust cycle under alternative monetary policy rules. In this context, we show that if the central bank tries to stabilize output, there would be a large real appreciation of the currency and a deep contraction in the tradable goods sector. When the central bank follows a more strict inflation targeting regime, the boom-bust pattern in major aggregate variables would be exacerbated. Finally, if the central bank attempts to sustain the real exchange rate, the perverse effects on the domestic tradable goods sector are only prevented in the short-run, but the boom-bust cycle in other variables is amplified.