Three Essays on Monetary Policy in Small Open and Developing Economies

Abstract

Abstract: This dissertation consists of three essays organized as chapters. On the first chapter, I revisit the discussions which evaluate different fluctuations of major economic variables produced by different monetary policy rules for small open economies, given the existence of liability dollarization. In particular, monetary rules which either include or exclude exchange rate stability as a monetary policy objective. I extend these argument by adding shocks to the risk premium for foreign borrowing to a calibrated small open economy DSGE model with sticky prices and monopolistic competition in the intermediate goods market. In addition I consider two monetary policy rules; one which put high weight on real exchange rate stability, and one which puts low weight on real exchange rate stability. With this model, I analyze the fluctuations of major macroeconomic variables under these two rules. It is found that there are variations in the fluctuations of the economic variables under these rules. In particular it is found that for risk premium shock, higher weights on real exchange rate stability in the monetary policy rule, amplifies the response of the macroeconomic variables. On the second chapter, I extend the model of the first paper by computing the optimal monetary policy rule under liability dollarization and given risk premium shocks. In this chapter I also consider three monetary policy rules; one which put high weight on real exchange rate stability, and one which puts low weight on real exchange rate stability and the optimal monetary policy rule, and analyze the fluctuations of major macroeconomic variables under these three rules. It is found that for risk premium shocks, higher weights on real exchange rate stability in the monetary policy rule, amplifies the response of the macroeconomic variables. However the welfare maximizing monetary policy rule result in more stable macroeconomic variables, but it requires some real exchange rate fluctuations. In the last chapter I attempt to answer two questions; how does foreign interest rate shocks and monetary policy shocks affect the quantity of bank credit to the domestic private non-financial sectors in small open developing countries? To what extent does monetary policy can influence the quantity of bank credit in these countries? This chapter uses a structural vector autoregressive (SVAR) model on a sample of six small open developing countries to answers these two questions. I found that an increase in foreign interest rates can either increase or decrease the quantity of bank credit, depending on how strong the increase in foreign interest rate shocks affect total interest income compared to the total interest cost of the bank's balance sheet. On the other hand, I found that the impact of a monetary contraction is to reduce the quantity of bank credit, which is consistent with the finding from previous literature. In addition, it is found that, at best, monetary policy can influence quantity of bank credit only in the short run. With the exception of Mexico, I found that both monetary policy and foreign interest rates influences the quantity of bank credit in these economies in the longer horizon. These results suggests that the monetary authority of the small open developing countries have limited influence on the quantity of domestic bank credit.