The Natural Interest Rate in Emerging Markets

An optimizing model of a small open emerging market economy (SOEME) with dualistic labour markets and two types of consumers, is used to derive the natural interest rate, terms of trade and potential output. Shocks are classified into generic types that affect the natural interest rates. Since parameters depend on features of the labour market and on consumption inequality, the natural rates and the impact of shocks differ from those in a mature small open economy. Subsistence consumption is found to have the largest effect on the natural rates. It reduces the interest rate, raises natural output and the terms of trade. Technology and infrastructure backwardness reduce natural output. The implications for monetary policy are derived. The effect of managed exchange rates combined with different types of inflation targeting is examined through simulations. Endogenous terms of trade make the supply curve steeper in a SOEME, so partial stickiness of the real exchange rate can be beneficial. In general, domestic inflation targeting, with some weight on the output gap, delivers lower volatility. Output response is higher and volatility lower with fixed terms of trade, demonstrating the flatter supply curve. CPI inflation targeting also does well when terms of trade are credibly fixed.