Monetary policy in a small open economy: the case of Paraguay

Abstract

The main motivation of this research work is that the Central Bank of Paraguay has announced a change in the current monetary policy objective based on the control of monetary aggregates, to an inflation targeting approach. The monetary authorities would need to adopt a more preventive posture to potential shocks that could turn aside from the inflation target. In this context the development of models capable to describe and analysis the current policy objective is crucial. When analyzing monetary policy objectives in open economies, the role of objective variables like exchange rate, inflation and output gap needs to have a special consideration. This work addresses the importance of these variables in a small open economy setting. It also implies a distinction between the consumer price index and the price index inflation. The small open economy framework can be used to assess the implications of alternative monetary policy rules for an open economy. This paper develops an open economy extension of the basic New Keynesian model of a small open economy model as a limiting case of a two country dynamic general equilibrium framework featuring monopolistic competition and price stickiness. Moreover, the framework assumes no trade frictions and perfect capital markets. The structure presented includes the small open economy setting developed by De Paoli (2006) and Gali (2007). This work allows analyzing the case of two policy rules for central banks: targeting and Taylor-type regimes. Moreover, study what is the measure of inflation that the monetary authority should seek to stabilize. Finally, this framework is used to determine the implications of the alternative rules and compared them to the Taylor rule for Paraguay.