Economic Stability in Small Open Economy under the Shadow of International Financiers

Cyril Dell'Eva () and Nicola Viegi
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Cyril Dell'Eva: LERN - Laboratoire d'Economie Rouen Normandie - UNIROUEN - Université de Rouen Normandie - NU - Normandie Université - IRIHS - Institut de Recherche Interdisciplinaire Homme et Société - UNIROUEN - Université de Rouen Normandie - NU - Normandie Université

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Abstract: We analyze economic dynamics and monetary policy response in a Small Open Economy model when the exchange rate is determined in a monopolistic competitive exchange rate market. In the model, international financiers act as intermediaries in bonds trading and their risk-bearing capacity determines how exchange rate react to capital flows. We use the model to reproduce the persistent depreciation observed in indebted countries and the appreciation enhanced by capital inflows. We then analyze the role of monetary policy in stabilizing the economy. Between simple policy rules, when the risk-bearing capacity of international financiers is low and the economy is hit by a demand shock, targeting domestic inflation achieve better domestic stabilization, at the cost of higher exchange rate volatility. Optimal policy though, by responding to exchange rate movements, neutralizes some of the real effects of exchange rate misalignment.

Keywords: Exchange rate; Financiers; Monetary policy; Risk-bearing capacity (search for similar items in EconPapers)
Date: 2024-12-19
Note: View the original document on HAL open archive server: https://normandie-univ.hal.science/hal-04847478v1
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