Monetary Policy under Imperfect Capital Markets in a Small Open Economy

Following the financial crises of the late 1990s an increasing number of emerging market countries have adopted a flexible exchange-rate regime and an inflation-targeting monetary-policy framework. This trend has generated a growing debate on the appropriate monetary-policy rule for financially fragile economies with thin and incomplete financial markets that are subject to highly volatile capital flows. Within this context, the paper examines the implications of alternative monetary-policy rules and the choice of instruments and targets in a small open economy with imperfect capital markets. The paper compares a benchmark efficient-markets model with a monetary-targeting regime and three different inflation-targeting rules: the Taylor rule, a CPI inflation-target rule, and a non-tradable inflation-target rule.