Working Paper No. 13-11

Cyclicality of Optimal Stabilization Policy in Developing Countries under Frictions: Role of Imperfect Infrastructural Development
Jongheuk Kim
November 2013, revised February 2014

ABSTRACT

A Rich volume of literature points out that many developing countries have experienced procyclical macroeconomic policies in recent period while most developed countries have not, but the reason of the phenomenon is still in debate. In this paper, I theoretically investigate an optimal fiscal and monetary policy in an economy where an imperfect infrastructural development influences on economic dynamics and cyclicality of macroeconomic stabilization policies. Based on a simple new Keynesian Dynamic Stochastic General Equilibrium (DSGE) model, a real quadratic adjustment cost that is created by a government spending spread between current and efficient level of the public expenditures is invited. This cost captures a negative effect of underdeveloped public infrastructure on trade-off between inflation gap and output gap stabilization encountered by policy authority. As a result, solving Ramsey policy problem with a linear-quadratic welfare loss function, I find that the optimal fiscal and monetary policy tend to be more procyclical and the economy experiences higher level of volatility in the presence of the imperfect infrastructural development. Comparing alternative monetary policy regimes based on Taylor rule, I find that a forward looking inflation rate targeting rule reduces procyclicality of fiscal and monetary policy and yields a significant improvement in welfare gain, while aggressive stabilization strategy on inflation gap or output gap has no economic merit.

 

JEL classification: E17, E52, E62
Keywords: Developing Countries, Monetary Policy, Procyclical Fiscal Policy, Infrastructure, Stabilization

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