Monetary Policy in Developing Economies A Hybrid Model with interventions in Forex markets

Resumen

The paper investigates the participation of an IT-central bank in the exchange rate market, as a supplemental tool for monetary policy. It presents a way of modeling a hybrid IT-regime with a managed float for a small open economy. The strategy followed, differs from most approaches that combine IT with partial control over the exchange rate, in that it uses the exchange rate as an operational target and interventions as instrument. The analysis is done in a general equilibrium setting, considering a financial system dominated by commercial banks, who solve an optimization problem giving rise to a premium in the UIP condition; Central bank’s behavior is described by two rules: a policy rate in a Taylor-type rule and another one describing the accumulation of international reserves. The model suggests that, when shocks affecting the economy are supply shocks, intervention in forex market can render better results than just re-setting the policy rate, in the sense that it reduces volatility of inflation, keeping it closer to its long run-level. For other type of shocks, intervention exacerbates inflation volatility.