An Educational Model of a Small Open Economy for Monetary Policy Analysis (with examples from Bank of Russia’s practice)

Alexandra Glazova (), Maxim Nevalennyi () and Andrey Sinyakov ()
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Alexandra Glazova: Bank of Russia, Russian Federation
Maxim Nevalennyi: Bank of Russia, Russian Federation
Andrey Sinyakov: Bank of Russia, Russian Federation

No wps154, Bank of Russia Working Paper Series from Bank of Russia

Abstract: This article presents a diagrammatic model of a small open economy. The dynamics of this graphical model are illustrated using impulse responses from the corresponding formal semi- structural model (Quarterly Projection Model, QPM). This graphical model reflects the modern understanding of how a fiat monetary economy and the current global financial system operate.1 It describes the specifics of monetary policy (MP) responses to supply and demand shocks under inflation targeting and the importance of anchoring inflation expectations. It explicitly considers the foreign exchange market (taking into account its potential imperfections) and demonstrates the role of the exchange rate in the transmission of MP. The model helps to link the global financial (credit) cycle to accumulating risks to financial stability, which create constraints on MP (‘dilemma, not trilemma’) and require the use of additional policy instruments. In our view, the presented diagrammatic model is a simpler version of the graphical model for analysing monetary policy in a small open economy than that proposed by Basu and Gopinath (2024). Therefore, it is suitable for less experienced readers—undergraduate students. The model not only accounts for the constraints facing monetary policy in a small open developing economy with developed financial markets but also allows for the analysis of extreme cases, like the closure of the financial account of the balance of payments and the associated changes in monetary policy transmission. Consequently, the model can be used to explain the rationale behind the Bank of Russia’s monetary policy decisions over the entire inflation targeting period. The authors provide a detailed analysis of the Bank of Russia’s decisions from 2022 onward using the model.

Keywords: monetary policy; small open economy; foreign exchange market; inflation targeting; monetary policy dilemma; diagrammatic general equilibrium model; Quarterly Projection Model (QPM); Bank of Russia (search for similar items in EconPapers)
JEL-codes: E58 F38 F41 G28 (search for similar items in EconPapers)
Pages: 125 pages
Date: 2025-08
New Economics Papers: this item is included in nep-mon
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