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- 2. The discount factor is 0.988, not far from the values found elsewhere in the literature (0.99), and coherent with an annual real interest rate of 4.8 percent, which is higher than the rate observed in the most advanced economies. The risk aversion coefficient is 1.5, within the range commonly used for this parameter in this kind of models. Labor supply elasticity equals 2, in line with Adolfson et al (2008).
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- 3. In the advanced economy, with a well-developed financial system, it is assumed that all consumers are able to optimize intertemporal consumption. Consequently, the proportion of consumption based solely on current income is assumed to be zero (i.e., = 0). In contrast, in the financially-vulnerable economy, the proportion of consumption based on current income, , is assumed to be 0.3, which is close to the values considered in other studies (Mankiw, 2000, and Galà et al, 2007).
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- 7. The elasticity of domestic exports to the real exchange rate is 5, given the strong competition small open economies face. In fact, it is possible to argue that domestic exporters face a similar elasticity to what is used in models for developed economies in the case of intermediate goods (Galà and Monacelli, 2005, Galà et al, 2007, Del Negro et al, 2005).
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Aizenman, Joshua, and Michael Hutchison, 2008, Inflation Targeting and Real Exchange Rates in Emerging Markets, NBER Working Paper 14561.
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- Brook, Anne-Marie, 2002, The Role of the Exchange Rate in New Zealand's Inflation Targeting Regime, Paper presented at the 14th Pacific Basin Central Bank Conference, Seoul, 2001.
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Céspedes, Luis, and Claudio Soto, 2005, Credibility and Inflation Targeting in an Emerging Market: Lessons from the Chilean Experience, International Finance, 8(3): 545575.
- Céspedes, Luis, Roberto Chang, and Andres Velasco (2004) Balance Sheets and Exchange Rate Policy American Economic Review 94(4), 118393.
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- Cavoli, Tony, 2006. Fear of Floating and Optimal Monetary Policy: with particular reference to East Asia. Queensland University of Technology, Mimeo.
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Cavoli, Tony, and R. Rajan, 2006, Monetary Policy Rules for Small and Open Developing Economies: A Counterfactual Policy Analysis, Journal of Economic Development 31(1), 89111.
Del Negro, M., F. Schorfheide, F. Smets, and R. Wouters, 2005, On the fit of new Keynesian Models Journal of Business & Economic Statistics 25(2):12362.
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Ehrmann, Michael, and Frank Smets (2003) Uncertain potential output: implications for monetary policy, Journal of Economic Dynamics & Control, 27: 16111638.
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- GalÃ, J., J.D. López-Salido, and J. Vallés, 2004 Rule-of-Thumb Consumers and the Design of Interest Rate Rules, Journal of Money Credit and Banking, 36(4):739763.
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- GalÃ, J., J.D. López-Salido, and J. Vallés, 2007, Understanding the Effects of Government Spending on Consumption Journal of the European Economic Association (5), 22770.
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Gertler, Mark, S. Gilchrist, and F. Natalucci, 2003, External Constraints on Monetary Policy and the Financial Accelerator, NBER Working Paper 10128.
Laxton, Douglas, and Pesenti Paolo, 2003, Monetary, Rules for Small, Open, emerging Economies, Journal of Monetary Economics.
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Mishkin, Frederic, 2000, Inflation Targeting for Emerging Market Countries, American Economic Review 90(2), 1059.
- Mishkin, Frederic, 2008, Discussion--Batini, Levine and Pearlman Monetary Policy Rules in a Partially Dollarized Small Open Economy with Financial Market Imperfections, presented at NBER Conference on International Dimensions of Monetary Policy, S'Agaro, Spain, June 12, 2007.
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- Monacelli, 2004 Into the Mussa Puzzle Monetary Policy Regimes and the Exchange Rate in a Small Open Economy Journal of International Economics.
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Morón, Eduardo, and Diego Winkelried, 2005, Monetary Policy Rules for Financially Vulnerable Economies, Journal of Development Economics 76, 2551.
Parrado, Eric, 2004, Inflation Targeting and Exchange Rate Rules in an Open Economy, IMF Working Paper 04/21 (Washington: International Monetary Fund).
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- These shares are in line with the priors of Adolfson et al (2008) and Smets and Wouters (2006). 6. Since imported goods are production inputs, we assume for simplicity that the elasticity of substitution between labor and imported goods is unity. Furthermore, we choose values close to 0.25 to define the share of imports in the production function, which also defines the degree of openness. Indeed, it implies a ratio of imports to GDP of 0.3. This ratio is common among small open economies, both emerging and developed.
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Tille, Cedric, 2001, The role of consumption substitutability in the international transmission of monetary shocks, Journal of International Economics 53(2): 42144.
Tovar, Camilo, 2006, Devaluations, output and the balance sheet effect: a structural econometric analysis, BIS Working Papers 215.
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Wei, Dong, 2008, Do Central Banks Respond to Exchange Rate Movements? Some New Evidence from Structural Estimation, Bank of Canada Working Paper 200824.