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Interest Rate Rules, Inflation Stabilization, and Imperfect Credibility: The Small Open Economy Case

Guillermo Calvo

No 13177, NBER Working Papers from National Bureau of Economic Research, Inc

Abstract: The paper examines the robustness of Interest Rate Rules, IRRs, in the context of an imperfectly credible stabilization program, closely following the format of much of the literature in open-economy models, e.g., Calvo and Végh (1993 and 1999). A basic result is that IRRs, like Exchange Rate Based Stabilization, ERBS, programs, could give rise to macroeconomic distortion, e.g., underutilization of capacity and real exchange rate misalignment. However, while under imperfect credibility EBRS is associated with overheating and current account deficits, IRRs give rise to somewhat opposite results. Moreover, the paper shows that popular policies to counteract misalignment, like Strategic Foreign Exchange Market Intervention or Controls on International Capital Mobility may not be effective or could even become counterproductive. The bottom line is that the greater exchange rate flexibility granted by IRRs is by far not a sure shot against the macroeconomic costs infringed by imperfect credibility.

JEL-codes: E52 E58 F32 F41 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-mac and nep-mon
Date: 2007-06
Note: IFM ME
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