Federal Reserve Bank of Chicago
Working Paper Series
Optimal Monetary Policy in an Open Emerging Market Economy
The majority of households across emerging market economies are excluded from the financial markets and cannot smooth consumption. I analyze the implications of this for optimal monetary policy and the corresponding choice of domestic versus external nominal anchor in a small open economy framework with nominal rigidities, aggregate uncertainty and financial exclusion. I find that, if set optimally, monetary policy smooths the consumption of financially excluded agents by stabilizing their income. Even though Consumer Price Index (CPI) inflation targeting approximates optimal monetary policy when financial inclusion is high, targeting the exchange rate is appropriate if financial inclusion is limited. Nominal exchange rate stability, upon shocks that create trade-offs for monetary policy, directly stabilizes the import component of financially excluded agents’ consumption baskets, which smooths their consumption and reduces macroeconomic volatility. This study provides a counterpoint to Milton Friedman’s long-standing argument for a float.
Cite this item
Tara Iyer, Optimal Monetary Policy in an Open Emerging Market Economy, Federal Reserve Bank of Chicago, Working Paper Series WP-2016-6, 20 Jun 2016.
- E24 - Macroeconomics and Monetary Economics - - Consumption, Saving, Production, Employment, and Investment - - - Employment; Unemployment; Wages; Intergenerational Income Distribution; Aggregate Human Capital; Aggregate Labor Productivity
- E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
- F21 - International Economics - - International Factor Movements and International Business - - - International Investment; Long-Term Capital Movements
- F31 - International Economics - - International Finance - - - Foreign Exchange
- F43 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Economic Growth of Open Economies
Keywords: Asymmetric Risk-Sharing; Fixed Exchange Rates; Financial Exclusion; Optimal Monetary Policy; Emerging Market Economies
This item with handle RePEc:fip:fedhwp:wp-2016-06
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