Uncertainty Shocks and Monetary Policy Rules in a Small Open Economy

Abstract

Post great financial crisis (GFC) of 2008-2009, there has been a surge in the macroeconomics literature on aggregate uncertainty. Although the recent literature has recognized adverse real effects of global uncertainty shocks in EMEs, the role of monetary policy in mitigating these effects is not studied. This paper explores the role of exchange rates (both nominal and real) and monetary policy in amplifying/ stabilizing the real effects of global uncertainty shocks in a small open economy. We reproduce stylized facts showing significant movements in exchange rates when EMEs are hit with a global uncertainty shock. We find that flexible inflation targeting regime using interest rate rules (IRRs) with floating exchange rates is ineffective in stabilizing the domestic economy during periods of high global uncertainty. Using a small open economy NK-DSGE model, we show that inflation targeting regime using exchange rate rules (ERRs) reduces welfare losses significantly compared to IRRs. This result contradicts the conventional wisdom which states that monetary policy following an IRR under floating exchange rate is welfare-maximizing in a small open economy.