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Monetary policy rules for an open economy with financial frictions: A Bayesian approach

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  • Aliaga Miranda, Augusto

Abstract

This paper evaluates optimal monetary policy in a new Keynesian model for an open economy with financial frictions. In the model, aggregate demand is made up of the weighted average of the short and long-term interest rates. A comprehensive set of monetary policy rules is established, all suitable for small open economies, such as Peru. A domestic inflation forecast based rule and an exchange rate based rule are found to work well. Furthermore, international shocks can affect competitiveness and involve co-movements in domestic interest rates. Finally, the estimates suggest that adding the nominal exchange rate to the monetary rule significantly improves the model fit. Consequently, the estimated parameters indicate that international shocks introduced in this model can replicate key empirical facts observed in the domestic business cycle.

Suggested Citation

  • Aliaga Miranda, Augusto, 2020. "Monetary policy rules for an open economy with financial frictions: A Bayesian approach," Dynare Working Papers 62, CEPREMAP.
    • Handle: RePEc:cpm:dynare:062
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    More about this item

    Keywords

    Bayesian estimation; Financial frictions; Open economy; Optimal monetary policy; Rules comparison;
    All these keywords.

    JEL classification:

    • C11 - Mathematical and Quantitative Methods - - Econometric and Statistical Methods and Methodology: General - - - Bayesian Analysis: General
    • E31 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Price Level; Inflation; Deflation
    • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
    • E44 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Financial Markets and the Macroeconomy
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies

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