Inflation, Real Exchange Rate and Monetary Policy in an Economy with Low Elasticity of Capital Flow on Interest Rate

Abstract

We consider a model of a small open economy that explains some important features of inflation and real exchange rate dynamics observed in the Russian economy and based on the assumption of low interest rate elasticity of capital flow. We demonstrate efficiency of the model in simulating the medium term dynamics of inflation and real exchange rate including the financial crisis of 1998 and its usefulness in forecasting the variables under given conditions including the current financial crisis. We derive a clear trade-off between inflation and real exchange rate appreciation in the presence of external shocks. We offer a comparative analysis of optimal monetary policy under conditions of low and high interest rate elasticity of capital flow.