Inflation persistence and exchange rate regime: Implications for dynamic adjustment to shocks in a small open economy

The paper examines implications of inflation persistence for business cycle dynamics following terms of trade shock in a small oil producing economy, under inflation targeting and exchange rate targeting regimes. It is shown that due to the ‘Walters critique’ effect, the country’s adjustment paths are slow and cyclical if there is a significant backward-looking element in the inflation dynamics and the exchange rate is fixed. It is also shown that such cyclical adjustment paths are moderated if there is a high proportion of forward-looking price setters in the economy, so that when the Phillips curve becomes completely forward-looking cyclicality in adjustment paths disappears and the response of the real exchange rate becomes hump-shaped. In contrast, with an independent monetary policy, irrespective of the degree of inflation persistence, flexible exchange rate allows to escape severe cycles, which results in a smooth response of the real exchange rate.     

Shocks to Terms of Trade and Risk-premium in an Intertemporal Model: The Dutch Disease and a Dutch Party

In this paper, we analyze the impact of terms of trade and risk-premium shocks on a small open economy in an intertemporal Dutch disease model, with international capital mobility. Given that an improvement in the terms of trade is associated with a decrease in the risk-premium on lending to this economy, we find that this can lead to a Dutch party (rather than Dutch disease) in which real exchange rate appreciation is associated with an expansion of the capital-intensive traded sector, hence, pro-industrialization. The economy also accumulates more debt in the long-run in response to the lower borrowing costs.