Policy mix in a small open emerging economy with commodity prices

Abstract

The article analyzes the interaction between monetary and fiscal policy in Mexico. We calibrated a semi-structural model for a small open economy, based on Aguilar and Ramírez-Bulos (2018), for Mexico by using quarterly data from 2001Q1 to 2019Q4. The fiscal policy block models the fiscal deficit depending on output, an endogenous sovereign risk premium, a state-owned oil company, and public debt dynamics with domestic and foreign components. We assumed a fiscal rule whereby the deficit has an upper bound. The monetary policy follows a Taylor rule. We study the effects of different shocks on the economy, such as a drop in commodity prices, an expansion of public spending, an increase in the risk premium, a hike in the interest rate, and depreciation of the real exchange rate. We show that, remarkably, the risk premium channel transmits threats from the fiscal block to the monetary block, calling for the central bank to stabilize inflation. By contrast, starting at the economy’s steady state, an exogenous monetary policy shock affects the fiscal block mainly through the interest rate’s influence on the debt service, prompting a fiscal response to stabilize deficit.