Cross border flows, financial intermediation and interactions of policy rules in a small open economy

Abstract

We investigate the interaction between monetary policy (MP) and macroprudential regulations (MaPs) in a small open emerging economy, using a New Keynesian DSGE model with financial intermediation. We show that an augmented Taylor rule (ATR), is inadequate to absorb negative shocks due to the conflict between inflation and exchange rate stabilization. However, two kinds of MaP regulations along with a simple monetary policy rule improve the business cycle dynamics and welfare under domestic and external shocks relative to ATR. The two macroprudential regulations analysed are relevant respectively for a ‘sudden stop’ type external shock or a banking crisis type domestic shock, which are frequent in such economies, and are found to improve macroeconomic stability.