A general equilibrium open economy model for emerging markets: Monetary policy with a dualistic labor market☆

a r t i c l e i n f o JEL classification: O11 E52 F41 Keywords: Small open emerging market Optimal monetary policy Dualism Inflation targeting Exchange rate An optimizing model of a small open emerging market economy (SOEME) with dualistic labor markets and two types of consumers, delivers a tractable model for monetary policy. Differences between the SOEME and the SOE are derived. Parameters depend on features of the labor market and on consumption inequality, and affect the natural interest rate, terms of trade and potential output. The supply curve turns out to be flatter and more volatile, with a larger number of shift factors, including policy-determined terms of trade. A simple basic version of the model is simulated in order to compare different policy targets in response to a cost shock. Flexible domestic inflation targeting gives the lowest volatility although there are trade-offs. Exchange rate volatility is relatively lower but still makes a major contribution to controlling inflation. Flexible CPI inflation targeting performs better when combined with some kind of managed floating. Inflation targeting has to be flexible. With more backward-looking behavior the policy response to a shock is reduced. In dynamic stochastic general equilibrium models with imperfect competition and nominal rigidities, monetary policy has substantial effects on real variables. The policy problem has been reduced to an elegant optimization subject to microfoundation based aggregate demand and supply curves with forward-looking behavior. 1 The coefficients of the equations satisfy the Lucas critique; derivation from basic technology, preferences and market structure makes them robust to policy changes. But the inclusion of frictions, and the emphasis on labor rather than capital, makes the framework applicable to the specific frictions and labor transition in emerging markets. This paper analyzes the differences in results if the small open economy in Galí and Monacelli (2005), an open economy model in this genre, is an emerging market with a large share of less productive labor in the process of being absorbed into the modern sector. So there are two types of consumers and labor: above subsistence (R), and at subsistence (P). While the first are able to smooth consumption using international markets, those at subsistence cannot. Their intertem-poral elasticity of consumption, productivity, and wages are lower and their labor supply elasticity is higher, compared to the first group, 2 because of their lower productivity. Inclusion of these two types partially addresses the Stiglitz …