Exploring counter-cyclical monetary policy in a small open economy using the portfolio balance approach

Whether or not the money supply is endogenously determined in response to demand variations has been the subject of recent debates. Regardless of the answer to this question, central banks can and do react to cyclical fluctuations, and their responses, in turn, affect the balance of payments and the foreign asset position. We explore the feasibility of a counter-cyclical monetary policy rule in a small open-economy portfolio balance set-up where assets are imperfect substitutes, capacity utilization endogenously adjusts in a neo-Kaleckian manner to clear the goods market, the exchange rate is flexible, and prices are fixed. This set-up, under some non-restrictive conditions, generates a stable steady-state solution, suggesting that a monetary policy based on a counter-cyclical interest-rate rule is a viable option for macroeconomic stabilization.