Monetary Policy in a Small Open Economy with High Unemployment

Abstract

A number of developing countries and emerging markets have now adopted inflation targeting as a framework for monetary policy. Yet some of these countries have high structural unemployment rates. One question that has not been addressed in the monetary policy literature is the implications of inflation-targeting in the context where the unemployment rate is in the double-digit range¹. The consensus view in macroeconomics within which many inflation-targeting central banks operate, summarized by Taylor (1997) and emphasized by Svensson (2003), says monetary policy cannot have long-run effects on the growth rate of output and the rate of employment. In this view, the growth rate of output in the long run is determined by the growth rate of labor productivity and the labor force. The seminal models, such as the ones in Svensson (1997, 1999), Ball (1999) and Clarida et al. (1999) among others, fall within this view.

Discussions about the desirability of inflation targeting hardly mention the labor market conditions of developing countries and emerging markets. For example, the extensive discussion in Agenor (2000), the presentation by Taylor (2000) and the recent IMF survey by Batini et al. (2006) do not address this question.