Monetary and Fiscal Rules in an Emerging Small Open Economy

We build a two-bloc DSGE emerging small open economy - rest of the world model to examine the implications of financial frictions for the relative contributions of fiscal and monetary stabilization policy. The model is calibrated using Chile data. Alongside the optimal Ramsey policy benchmark, we study a variety of simple monetary and fiscal rules including a fixed exchange rate regime and both domestic and CPI inflation targeting interest rate rules alongside a ‘Structural Surplus Fiscal Rule’ as followed recently in Chile. We find that domestic inflation targeting is superior to partially or implicitly (through a CPI inflation target) or fully attempting to stabilizing the exchange rate. Financial frictions require fiscal policy to play a bigger role and lead to an increase in the costs associated with simple rules as opposed to the fully optimal policy.