Monetary Policy Under Imperfect Capital Markets in a Small Open Economy

Abstract

Following the financial crises of the late 1990's an increasing number of emergingmarket countries have adopted a flexible exchange-rate regime and an inflation-targeting monetary-policy framework. This trend has generated a growing debate on the appropriate monetary-policy rule for financially fragile economies with thin and incomplete financial markets that are subject to highly volatile capital flows. Within this context, I examine the implications of alternative monetary-policy rules and the choice of instruments and targets in a small open economy with imperfect capital markets. I compare a benchmark efficient-markets model with a monetary-targeting regime and three different inflation-targeting rules: the Taylor rule, a CPI inflation-target rule, and a non-tradable inflation-target rule. Furthermore, I study how sensitive the results are to varying degrees of capital-market integration.