Financial Integration and Cyclicality of Monetary Policy in Small Open Economies

Abstract

Should countries follow counter-cyclical or pro-cyclical monetary policies? This paper documents that in contrast to developed economies, developing countries tend to follow pro-cyclical monetary policies. The paper then constructs a New-Keynesian small open economy model with wage rigidity and solves for the optimal monetary policy under different levels of integration in the international financial markets. The model suggests that as economies gain accessibility to the international financial markets the optimal monetary policy shifts from pro-cyclical to counter-cyclical. This result may rationalize the observed difference in monetary policies between developed and developing countries.

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