Financial and price stability in emerging markets: the role of the interest rate

The Global Financial Crisis opened a heated debate on whether inflation target regimes must be relaxed and allow for monetary policy to address financial stability concerns. Nonetheless, this debate has focused on the ability of the interest rate to "lean against the wind" and, more generally, on the accumulation of systemic risk arising from the macro-financial challenges faced by advanced economies. This paper extends the debate to emerging markets by developing micro-foundations that allow extending a simplified version of the New-Keynesian credit augmented model of Curdia and Woodford (2016) to a small-open economy scenario, and by subsequently using the same empirical strategy as Ajello et al. (2015) to calibrate the model for Mexico. The results suggest that openness in the capital account, and in particular a strong dependence of domestic financial conditions on capital flows, diminishes the effectiveness of monetary policy to lean against the wind. Indeed, in the open-economy with endogenous financial crises, the optimal policy rate is even below the level that would prevail in the absence of endogenous financial crisis and systemic risk.