“Monetary and Fiscal Rules in an Emerging Small Open Economy”

IMF Working Papers, January 1, 2009

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Develops an optimal rules-based interpretation of the "three pillars macroeconomic policy framework": a combination of a freely floating exchange rate, an explicit target for inflation, and a mechanism that ensures a stable government debt-GDP ratio around a specified long run.
Shows how monetary-fiscal rules need to be adjusted to accommodate specific features of emerging market economies.
Uses a two-bloc DSGE model of an emerging small open economy interacting with the rest of the world, featuring financial frictions.
Calibrated using Chile and US data.
Compares simple monetary and fiscal rules with the optimal Ramsey policy benchmark and with a fixed exchange rate regime.

Two-bloc DSGE emerging small open economy interacting with the rest of the world.
Key model feature: financial frictions.
Calibration: Chile and US data.

Monetary rules:
- Domestic inflation targeting interest rate rule.
- CPI inflation targeting interest rate rule (implicit partial exchange rate stabilization).
Fiscal rule:
- "Structural Surplus Fiscal Rule" as recently followed in Chile.
Policy regimes compared:
- Freely floating exchange rate with the three-pillar rules.
- Fixed exchange rate regime.
- Fully optimal (Ramsey) policy benchmark.

Domestic inflation targeting is superior to partially or implicitly (through a CPI inflation target) or fully attempting to stabilize the exchange rate.
Financial frictions increase the role of fiscal policy.
Financial frictions lead to an increase in the costs associated with simple rules as opposed to the fully optimal policy.
The three-pillar framework must be adjusted for features of emerging market economies to achieve optimal outcomes.