From Money Aggregates to Interest Rate Rules in a Small Open Economy: A Second Order Approach

We evaluate the second order solution of a general equilibrium model for a small open economy in the line of the "new open economy macroeconomics". We use this framework to explain some recent regularities observed in economies in which central banks move from using a money aggregate as the target towards a regime based on the control of the short-term interest rate. In particular, in those economies we observe that after the change of policy rule there is a decrease in the unconditional volatilities accompanied by a reduction in the unconditional mean in inflation and interest rates vis-a-vis an increase in the unconditional mean in money aggregates. By analyzing the second order solution we relax the assumption of certainty equivalence which permit us to consider the role of uncertainty in the equilibrium solution. Overall, unlike the linear approach, the second order solution of the model allow us to capture the decrease in the unconditional means of interest rate and inflation along with an increase in the unconditional mean of the money demand as a consequence of the reduction of volatility due to the change of regime, as it is observed in the data. The main mechanism stems from different forms of risks that arise from the second order solution.