Monetary policy rule, exchange rate regime, and fiscal policy cyclicality in a developing oil economy

According to Frankel and Catao (2011), a commodity-exporting developing economy is advised to target the product price rather than consumer price, as the former monetary policy is automatically countercyclical against the volatile terms of trade shock. This paper constructs a dynamic stochastic general equilibrium model of joint monetary and fiscal policies for a developing oil economy, to find an appropriate monetary rule combined with a pro/counter/acyclical fiscal stance based on a loss measure. The foreign exchange interventions distinguish between a managed and flexible exchange rate regime, while fiscal policy cyclicality depends on the oil output response of public consumption and public investment. The study reveals that the best policy combination is a countercyclical fiscal stance and consumer price monetary targeting under a managed exchange rate regime to stabilize the domestic price inflation, aggregate output, and real exchange rate in a small open economy.