Interest Rate Policy in a Small Open Economy: The Predetermined Exchange Rates Case

An important obstacle encountered in analyzing interest rate targeting is that standard models usually lead to indeterminacy of the price level or the inflation rate. This paper develops a simple framework that avoids such problems, because the bonds whose interest rate is controlled provide liquidity services. This framework is used to examine interest rate policy in a small open economy under predetermined exchange rates. A permanent increase in the interest rate has no real effects, whereas a temporary increase in the interest rate leads to higher consumption and a current account deficit that worsens over time.