An Educational Model of a Small Open Economy for Monetary Policy Analysis (with examples from the practice of the Bank of Russia)
Alexandra Glazova, Maksim Nevalennyi, Andrey Sinyakov
The paper proposes a graphical model of a small open economy. The dynamics of the graphical model is then illustrated using impulse responses from the corresponding formal semi-structural model (QPM model).
The authors have several goals in preparing this description of the graphical macroeconomic model.
The first goal of the paper is to present an adapted version of the graphical model of decision making by a modern central bank for readers who may have difficulty immediately understanding advanced graphical models, such as Basu and Gopinath (2024). Our task is to prepare the educational materials for students studying the courses “Macroeconomics” or “Monetary Policy” in universities.
The graphical model reflects modern ideas about how the monetary (fiat) economy and the global financial system work. In particular, it takes into account: the difference between “inside” and “outside”; the role of commercial banks and financial markets in financing aggregate demand; the long term money neutrality; inflation targeting as the ultimate goal of monetary policy; targeting the money market interest rate as the operational framework of monetary policy (MP); channels of monetary policy transmission through which the regulator can influence inflation; the impact of financial crises on the ability of commercial banks to create money for the economy. The article describes specifics of monetary policy (MP) in its reaction to supply and demand shocks and shows the importance of anchoring inflation expectations. The foreign exchange market is explicitly modeled (taking into account its possible imperfections) and the role of the exchange rate in the transmission of MP is shown.
A related task is to take into account the limitations that monetary policy faces in a small open developing economy with developed financial markets. The ability of key central banks to launch global financial and credit cycles leads to the emergence of a “dilemma, not a trilemma” of monetary policy. In the graphical model, the authors analyze this situation, showing its causes. From this analysis, it becomes clear what tools can help overcome the “dilemma” and untie the hands of the monetary policy in controlling inflation in the regime of a flexible exchange rate and an open capital account. It is important that some of these tools actually have as their original goal to limit the accumulation of financial stability risks. However, their side effect is monetary policy independence. The Bank of Russia in practice actively uses some of these tools, such as macroprudential measures.
The second goal is to describe the changes that have occurred in connection with the onset of the “new reality” in 2022 and how this has affected the logic of decisions made on monetary policy. A typical textbook focuses on the case of a small open economy. In Russia, in 2022, strong changes occurred that affected the economy and the transmission of monetary policy. The model allows one to analyze the closing of the financial account of the balance of payments and the associated changes in the transmission of monetary policy. The authors analyze the logic of the Bank of Russia’s decisions since 2022 based on the model.
The authors hope that the presented model, either as a whole or as separate blocks or even the logic of the model itself, will be in demand by university professors when they teach the course “Macroeconomics” or “Monetary Policy” for undergraduate students in economics.