Macroeconomic instability and targeting rules for monetary policy in an endogenously growing small open economy

Abstract

By using the feature that money can lower unit transaction costs, this paper develops a monetary endogenous growth model for a one‐sector small open economy, and uses it to examine the possibility of the occurrence of belief‐driven fluctuations. It is found that the emergence of belief‐driven fluctuations is crucially related to targeting rules for monetary policy. More specifically, when the monetary authorities target the specific money growth rate, macroeconomic instability generated by belief‐driven fluctuations can arise even if labor externalities are totally absent. This finding runs in sharp contrast to the Benhabib–Farmer assertion needed for the occurrence of belief‐driven fluctuations. It is also found that, when the monetary authorities target the specific inflation rate, macroeconomic instability generated by belief‐driven fluctuations can never prevail regardless of the extent of the unit transaction costs.

The Effect of Inflation on Wage Inequality: A North–South Monetary Model of Endogenous Growth with International Trade

“…In fact, there are quite a few examples of works that study an open economy monetary endogenous growth model. The exceptions are Chen et al (2020) and Chu et al (2015Chu et al ( , 2019. The first devises a small open economy growth model analyzing if monetary policy changes the possibility of macro-economic instability in the model.…”