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The 2008 financial crisis is marked by the drop in output of major industrial countries which affected small open economies in various degrees. We examine the role of three different types of monetary policy rules in mitigating or exacerbating the effects of a negative foreign output shock on key macroeconomic variables of a small open economy by numerically solving a dynamic stochastic general equilibrium (DSGE) model. We find that compared to the Taylor rule, small open economies that follow either fixed exchange rate regime or strict inflation targeting tend to stabilize real exchange rate and inflation at the expense of substantial instability in the real economy.

The most recent financial crisis in the United States began to unfold soon after the bursting of housing market bubble in the mid-2000. The steep drop in housing prices made it difficult for homeowners to refinance their mortgages forcing them to default on their loans. The drop in housing prices also reduced the values of financial instruments linked to home mortgages. The default in housing loans and the reduction in the values of mortgaged-backed financial instruments caused US financial institutions to suffer heavy losses and to restrict lending to the rest of the economy. The resulting credit crunch affected the other sectors of the US economy and, as shown in Fig. 1, US real GDP began to decline in the first quarter of 2008. From this benchmark date, the cumulative change in US real GDP growth over the trend is estimated to be −6.7%.1 Financial institutions in the United Kingdom, France and other industrialized countries that bought US mortgage-backed financial instruments also suffered heavy losses causing a credit crunch in their respective markets. Real GDP of G-7 countries declined around the first quarter of 2008 and had a cumulative change in real GDP growth over the trend of −7.8%. Full-size image (59 K) Fig. 1. GDP volume (2001 = 100) of selected industrial countries. Figure options Fig. 2 shows that emerging countries with small open economies have been adversely affected by the financial crisis even though most of their financial institutions had low exposure to US mortgage-backed financial instruments.2 For these countries, the drop in real GDP could be due to the decline in exports as output and real income in industrial countries declined. In other words, emerging economies with relative sound financial institutions were largely affected by the 2007–2008 financial crisis through foreign output shock. In addition, Fig. 1 shows that the real GDP of Hong Kong and Taiwan are more volatile than Israel and South Korea from 2003 to 2009. Full-size image (50 K) Fig. 2. GDP volume (2001 = 100) of selected emerging countries. Figure options The findings in Fig. 2 are confirmed in Table 1 which shows that cumulative changes in real GDP of Israel, South Korea, Taiwan and Hong Kong varied significantly across countries. Among these small open economies, both Hong Kong and Taiwan are the most deeply affected countries. Table 1 also shows that Taiwan's exchange rate appreciated by 3% against the US dollar while Hong Kong's exchange rate had a slight appreciation of 0.4%. In contrast to the rigidity in the New Taiwan dollar and the Hong Kong dollar, South Korea and Israel's national currencies depreciated considerably against the US dollar. However, the average change in CPI is also much larger in South Korea and Israel than in Hong Kong and Taiwan.3 Table 1. Country Cumulative percentage change in real GDP growth Average percentage change in CPI inflation Average percentage change in national currency to US dollar Israel −6.66 2.64 14.78 South Korea −7.65 1.32 27.16 Taiwan − 12.04 0.14 − 3.01 Hong Kong, China − 13.08 0.38 − 0.42 Benchmark country: USA − 6.72 − 1.29 Notes: we consider 2008 Q1 as the benchmark date of the 2008 financial crisis. We follow Blanchard and Gali (2007) in calculating the cumulative change in real GDP gain or loss over eight quarters following benchmark date relative to the trend given by the cumulative real GDP growth rate over the preceding eight quarters. The change in CPI inflation (National currency to US dollar) is the average rate of inflation (depreciation or appreciation) in eight quarters following each of the benchmark date minus the average inflation (depreciation or appreciation) rate over the eight quarters immediately following the benchmark date. A positive (negative) sign in the fourth column indicates the depreciation (appreciation) of the national currency against the US dollar. Quarterly data are from International Financial Statistics for Israel, South Korea, Hong Kong and USA and from DataStream International for Taiwan. Table options Why were some countries so adversely affected than others in the face of a negative foreign output shock? What role did monetary policy play in mitigating or exaggerating the negative foreign output shock? The answers to these questions have been of concern and interest to international macroeconomists and policy makers alike. The extent to which an economy is insulated — and the channels of transmission to which economies respond — to foreign output shocks may depend on the types of exchange rate regimes and monetary policy rules. One of the main arguments in favor of allowing exchange rates to float is the ability of flexible regimes to insulate and cushion the economy more effectively against real shocks. This hypothesis was proposed by Friedman (1953) and subsequently Mundell (1961). In the presence of price stickiness, flexible exchange rates act as a shock absorber in a small open economy. When an economy is hit by real shocks, the economy that can change relative prices more quickly will have smaller and smoother adjustment in output. Flexible exchange rates allow relative prices to adjust instantly through changes in the nominal exchange rates. However, fixed exchange rates restrict the relative prices to adjust only at the much slower speed that is permitted by price stickiness. The proposition made by Friedman and Mundell has subsequently spurred the interest of international macroeconomists to look into the response of economies, both large and small, to a comprehensive set of external shocks under different exchange rate regimes. Some have focused on theoretical models and others on empirics. Theoretical models include the work of Poole, 1970, Dornbusch, 1980 and Läufer, 1994, and more recent studies of Obstfeld and Rogoff, 2000, Devereux, 2004 and Devereux et al., 2006. While conclusions from theoretical studies remain highly contentious, available empirical evidence, regardless of the types of external shocks, generally confirms Friedman's proposition. For instance, Broda (2004) examines the effects of terms of trade changes on 75 developing countries from 1973 to 1996 under different exchange rate regimes. The short-run real GDP response to terms of trade shocks is significantly smaller in countries with flexible exchange rate regimes than those with fixed exchange rate regimes. More pertinent to our study, Hoffmann (2007) shows significant differences in the variability of macroeconomic aggregates under fixed and flexible exchange rate regimes under foreign output shocks or world output shocks in 42 developing countries. Specifically, he shows that countries which allow the nominal exchange rate to fluctuate achieve a steadier adjustment of real GDP. The mitigated decline of real GDP under flexible exchange rate regimes is explained by real exchange rate depreciation, which moderates the negative foreign output shocks. The main purpose of this study is to conduct an investigation on the role of alternative monetary policy rules for a small open economy in mitigating negative foreign output shocks originating from the rest of the world. We develop a dynamic stochastic general equilibrium (DSGE) model with a goods market featuring imperfect competition and nominal rigidities. In recent years, there has been an outpouring research on open economy DSGE models that incorporate imperfect competition and nominal rigidities. Since the publication of the Redux model by Obstfeld and Rogoff, 1995 and Obstfeld and Rogoff, 1996, the research on open economy macroeconomics has produced a synthesis of dynamic intertemporal approaches with sticky-price models of macroeconomic fluctuations. This synthesis has subsequently become widely known as the new open economy macroeconomics, NOEM. This new class of models has allowed economists to tackle many classical problems with new tools and at the same time generated new ideas and questions. In this study, we describe the response of the small open economy to foreign output shocks under three types of monetary policy rules: a fixed exchange rate rule, a strict inflation targeting rule and the Taylor-type rule. The open economy framework allows us to consider the exchange rate channel in the transmission of foreign output shocks to the economy. Foreign output shocks are assumed to be exogenous to country-level variables. In contrast to many DSGE models which consider only two factor inputs, we follow Kim and Loungani (1992) in considering oil as an input in a constant elasticity of substitution (CES) production function where oil and capital are substitutes. As in Monacelli (2004), capital is subject to adjustment costs. The model has a monetary policy rule that assigns different weights on the output gap, inflation and deviations of nominal exchange rate from theoretical parity. By explicitly analyzing the response of the economy to foreign output shocks under different types of monetary policy rules, this paper does not only address the question of the extent to which the volatility of output can be attributed to foreign output shocks but also help to identify the dynamics of various macroeconomic aggregates including output, inflation, terms of trade, nominal and real exchange rates. Consistent with the empirical evidence documented by Hoffman (2007), the comparison between responses of alternative monetary policy rules suggests that (1) both fixed exchange rate regime and strict inflation targeting tend to stabilize real exchange rate and inflation at the expense of substantial instability in the real economy, (2) the mitigated decline in real output under the Taylor-type rule is explained by the large depreciation of nominal and real exchange rates, and (3) inflation rate is most moderate under strict inflation targeting. Consistent with the prediction of Friedman, long-run differences across regimes are not significant. The remainder of the paper is as follows. Section 2 specifies the model. Section 3 discusses the main results. Section 4 concludes.

The 2008 financial crisis is marked by the drop in output of major industrial countries which affected small open economies in various degrees. We isolate one specific type of shock, the negative foreign output shock, and examine how countries with different monetary policy rules cope with this shock using a dynamic stochastic general equilibrium (DSGE) model with sticky prices and imperfect competition in the goods market. The alternative monetary policy rules considered are fixed exchange rate regime, strict inflation targeting, and the Taylor rule. Most interestingly, the simulation results are able to scrutinize Hoffman's empirical evidence and identify significant differences in the responses to foreign output shocks across monetary policy rules. Compared to the Taylor-type rule, fixed exchange rate regime and strict inflation targeting tend to keep nominal exchange rate and inflation from adjusting and prevent the real exchange rate from depreciating so that the negative of a fall in foreign output is passed through the domestic economy. The mitigated decline in real output under the Taylor-type rule is explained by a larger depreciation of nominal and real exchange rates. Besides, we also find that inflation rate is most moderate under strict inflation targeting and nominal exchange rate is stable under pegs.