A General Equilibrium Open Economy Model for Emerging Markets – Monetary Policy with a Dualistic Labor Market

An optimizing model of a small open emerging market economy (SOEME) with dualistic
labour markets and two types of consumers, delivers a tractable model for monetary policy.
Differences between the SOEME and the SOE are derived. Parameters depend on features of
the labour market and on consumption inequality, and affect the natural interest rate, terms
of trade and potential output. The supply curve turns out to be flatter and more volatile, with
a larger number of shift factors. A simple basic version of the model is simulated in order to
compare different policy targets in response to a cost shock. Flexible domestic inflation
targeting delivers stability and the lowest volatility. Some weight on output and on interest
smoothing allows monetary policy to be less contractionary. Exchange rate flexibility is less
but still makes a major contribution to controlling inflation.