External Debt and Taylor Rules in a Small Open Economy

• Date: 01 December 2016
• Author: Kenya Takaku,Shigeto Kitano
• DOI: http://doi.org/10.1111/1468-0106.12156
• Published date: 01 December 2016

EXTERNAL DEBT AND TAYLOR RULES IN A SMALL

OPEN ECONOMY

SHIGETO KITANO*Kobe University

KENYA TAKAKU Aichi Shukutoku University

Abstract. We develop a dynamic stochastic general equilibrium model of a small open economy in

which both price rigidity and financial friction exist. We compare two cases featuring different inter-

est rate rules. Both cases use the standard Taylor-type interest rate rules, but the second case also

considers external debt levels. We find that when friction in foreign borrowing is large, adding an ex-

ternal debt level to Taylor rules improves welfare. The welfare curve, however, exhibits a hump

shape because excessive reactions to changes in external debt reduce welfare.

1. INTRODUCTION

Taylor rules are simple monetary policy rules that govern how a central bank

should systematically adjust the nominal interest rate in response to changes

in inflation and other macroeconomic variables. Since Taylor (1993), a large

body of literature has shown that these rules provide a reasonable empirical

description of the policy behaviour exhibited by many central banks (e.g.

Clarida et al., 1998).

In addition, further studies have examined whether welfare can be improved if

other macro-variables such as foreign exchange rates and asset prices are added

to the standard Taylor rules. Taylor (2001) surveys literature examining the pol-

icy effect when exchange rates are added to Taylor rules (e.g. Ball, 1999;

Svensson, 2000). Taylor (2001) concludes that the economic improvement

would be small or might even decline if exchange rates are added when control-

ling inflation rate and output gap volatility. Senay (2008) performs a welfare

analysis based on a small open dynamic stochastic general equilibrium (DSGE)

model with price rigidity and micro-foundations. The results suggest that includ-

ing exchange rates would reduce welfare.

1

Bernanke and Gertler (1999) incor-

porate a bubble crisis into the financial accelerator model of Bernanke et al.

(1999) and contemplate whether to add asset prices to Taylor-type interest rate

rules. They conclude that monetary authorities should not consider asset prices

in their monetary policy. However, Cecchetti et al. (2000) consider a generalized

1

The theoretical models in the literature presented by Taylor (2001) lacked micro-foundations.

Whereas Svensson (2000) developed a model based on micro-foundations, the welfare loss function

is set in an ad hoc way.

*Address for Correspondence: RIEB, Kobe University, 2-1, Rokkodai, Nada, Kobe, 657-8501 Japan.

E-mail: kitano@rieb.kobe-u.ac.jp. Earlier versions of the paper were presented at the tenth annual

conference, Asia-Pacific Economic Association in Bangkok, the Japan Society of Monetary Eco-

nomics, and Kobe University. The authors thank the seminar participants for helpful comments.

The authors are especially grateful to two anonymous referees, Takashi Kamihigashi, Ryo Kato,

Masahiko Shibamoto, Eiji Okano, and Chikafumi Nakamura for valuable comments. Any remain-

ing errors are ours. This work was supported by Grants-in-Aid for Scientific Research.

Pacific Economic Review, 21: 5 (2016) pp. 541–559

doi: 10.1111/1468-0106.12156

© 2016 John Wiley & Sons Australia, Ltd

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version of the model used by Bernanke and Gertler (1999) and advise that inter-

est rates respond to stock prices.

The recent financial crisis has revived the long-standing debate concerning

whether monetary authorities should consider variables other than inflation

and output gaps. More recent studies have suggested that the central bank

may improve welfare by including such additional variables in monetary policy

rules. Studies such as those by Christiano et al. (2007), Christiano et al. (2008),

Cúrdia and Woodford (2010) Gray et al. (2011) and Kannan et al. (2012) show

that gains can result from including additional variables such as credit growth,

credit spreads or financial stability indicators.

The present paper focuses on emerging market economies. Business cycles in

such economies are amplified by recurrent capital flow booms and busts. In-

creasing interest in this phenomenon has resulted in a fast-growing body of lit-

erature investigating prudential policies concerning capital inflows (e.g. Jeanne

and Korinek, 2010; Korinek, 2011; Jeanne et al., 2012).

2

Building on this

background, we develop a model that includes external debt in the standard

Taylor rules. We consider whether it is welfare improving to use monetary pol-

icy to increase interest rates when capital inflows are booming and external

debt is accumulating. To examine whether including external debt in the stan-

dard Taylor rules may improve an economy’s welfare, we develop a standard

DSGE model of a small open economy calibrated to reflect emerging market

economies, incorporating both price rigidity and a reduced form of financial

friction à la Garcia-Cicco et al. (2010).

Our argument is closely related to the argument made by Garcia-Cicco et al.

(2010) on a country-specific interest-rate premium. Garcia-Cicco et al. (2010)

show that the country-specific interest-rate premium parameter can play an im-

portant role in replicating the business cycle seen in emerging market economies.

Moreover, they argue that ‘the role of the debt elasticity of the country premium

is no longer limited to simply inducing stationarity, but to potentially act as the

reduced form of a financial friction shaping the model’s response to aggregate

disturbances’(p. 2522). The country premiums of emerging market economies

are significantly higher than those of developed countries. In addition, the coun-

try premium rises as a country accumulates external debt. Our analysis shows

that as the debt elasticity of the country premium rises, it becomes increasingly

important for policy-makers in emerging market economies to incorporate

external debt levels into their monetary policy decisions.

The remainder of the paper is organized as follows. In Section 2, we present a

DSGE model of a small open economy including both price rigidity and finan-

cial friction. In Section 3, we calibrate our model to match key characteristics

of emerging economies. In Section 4, we perform a comparative analysis of wel-

fare in two interest rate rule scenarios. Both cases use the standard Taylor-type

interest rate rules, but the second case also considers external debt levels. Con-

clusions are presented in Section 5.

2

For details on the new literature on capital controls, see Korinek (2011) or Jeanne et al. (2012). For

the earlier literature, see the introduction in Kitano (2011).

S. KITANO AND K. TAKAKU542

© 2016 John Wiley & Sons Australia, Ltd