Monetary Policy Transmission in a Small Open Economy under Financial and Trade Restrictions

K. Styrin

This paper studies how the effect of macroeconomic shocks on inflation depends on the severity of restrictions on international borrowing and imports. Using a calibrated model of a small open economy, I show that the effect of a change in the terms of trade, while being neutral in the absence of these restrictions, becomes inflationary in their presence. Inflation pressures emerge due to a higher interest rate on external borrowing, which is raised in order to pay for imports, and also due to trade costs, which have a direct effect on the domestic price of imported goods. As a consequence, monetary policy in the presence of restrictions on financial and trade transactions becomes tighter.

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