Monetary policy rules for financially vulnerable economies

This study examines appropriate monetary policy rules for emerging economies with high levels of liability dollarization, focusing on the cases of Peru and Uruguay under an inflation-targeting regime (ITR). It examines the effectiveness of the ITR in vulnerable economies that face significant risks associated with real exchange rate depreciation, which can amplify financial fragility. Using a small open-economy model, calibrated with data from these countries and other robust economies such as Australia and New Zealand, the study analyzes different monetary rules to determine which is optimal for mitigating extreme volatility in critical economic variables. The results suggest that a nonlinear rule—one that allows for a stricter response to significant exchange rate depreciations—is more effective at balancing price stability and growth. The study’s implications highlight the need for caution when adopting an EMI in contexts of high liability dollarization, where an unsustainable monetary policy could increase economic vulnerability rather than reduce it. (Abstract and audio: Department of Economic Publications)