Foreign exchange constraints and macroeconomic dynamics in a small open economy

Firms in most low-income countries depend almost entirely on imported capital and intermediate inputs. As a result, the availability and cost of foreign exchange play a crucial role on the macroeconomic performance of these countries. In this study we introduce foreign exchange constraints that importing firms face and the foreign exchange reserve management problem of the central banks in such economies into a small open economy New Keynesian model. We calibrated the model to the Ethiopian economy. Our simulation experiments show that given the foreign exchange constraints and the standard monetary policy rule, contractionary monetary policy leads to expansion in output and consumption and contraction in employment. This effect is more pronounced if the duration of price stickiness for the imported goods is short relative to that of the domestically produced goods which seems to be the case for countries like Ethiopia. This result, to the minimum, reminds us that one needs to be cautious about the effectiveness of conventional macroeconomic policies when applied to low-income countries.