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Uncertainty shocks and monetary policy rules in a small open economy

Published online by Cambridge University Press:  16 May 2024

Sargam Gupta
Sargam Gupta*
Affiliation:
Indira Gandhi Institute of Development Research (IGIDR), Mumbai, India
*
Emails: sargamgupta.6@gmail.com, sargam@igidr.ac.in
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Abstract

Post the great financial crisis (GFC) of 2008–2009, there has been a surge in the macroeconomics literature on aggregate uncertainty. Although the recent literature has recognized the adverse real effects of global uncertainty shocks in emerging market economies (EMEs), the role of monetary policy in offsetting these adverse effects and their link with the exchange rates is not explored in the literature. We find that the currently followed interest rate rules (IRRs) under a flexible inflation-targeting regime are ineffective in stabilizing the domestic economy during periods of high global uncertainty in the EMEs. Using a small open economy new Keynesian DSGE model with Epstein–Zin preferences and second-moment demand shocks, we compare and propose alternate monetary policy rules that significantly reduce welfare losses. We find that the best monetary policy rule in terms of welfare depends on the nature of shock that is, first-moment or second-moment shock.

Keywords

uncertainty shockslocal projectionsnew Keynesian DSGE modelmonetary policy rulesuncovered interest rate parityrisk premiumsE31E42E43E52E58F41
Type
Articles
Information
Macroeconomic Dynamics , Volume 29 , 2025 , e18
Copyright
© The Author(s), 2024. Published by Cambridge University Press

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