Financial Integration And Cyclicality Of Monetary Policy In Small Open Economies

Should countries follow counter-cyclical or pro-cyclical monetary policies? This paper documents that in contrast to developed economies, developing countries tend to follow pro-cyclical monetary policies. The paper then constructs a New-Keynesian small open economy model with wage rigidity and solves for the optimal monetary policy under di??erent levels of integration in the international financial markets. The model suggests that as economies gain access to the international financial markets the optimal monetary policy shifts from pro-cyclical to counter-cyclical. Also, when economies are denied access to financial markets the optimal policy partially o??set exchange rate movements which may be perceived as “fear of floating”. Results are robust to a wide range of parameter values and utility specifications.