Monetary Policy, Informality and Business Cycle Fluctuations in a Developing Economy Vulnerable to External Shocks

This paper develops an open economy dynamic stochastic general equilibrium (DSGE) model based on New-Keynesian micro-foundations. Alongside standard features of emerging economies, such as a combination of producer and local currency pricing for exporters, foreign capital inflow in terms of foreign direct investment and oil imports, this model also incorporates informal labour and production sectors. This customisation intensifies the exposure of a developing economy to internal and external shocks in a manner consistent with the stylised facts of Business Cycle Fluctuations. We then focus on optimal monetary policy analysis by evaluating alternative interest rate rules and calibrate the model using data from Pakistan economy. The learning and determinacy analysis suggest monetary authority in developing economies to follow Taylor principle in large and to put some weight on exchange rate fluctuations even if there is relatively less inertia in the setting of policy interest rate.