Inflation Expectations in a Small Open Economy

Abstract

This paper studies the dynamics of the formation of inflation expectations in small and open economies, based on an agent-based model (ABM). Agents are assumed to have a limited rationality to adapt their strategies over time and to have difficulty at perceiving the signals from the Central Bank (CB). The CB tries to achieve a target inflation by setting an inflation rate. The monetary authority is committed to a certain level toward which it is directed with monetary policy instruments – the interest rate, in this economy. To achieve this goal, it is essential that the expectations of the private sector get aligned with the objective proposed by the CB. The CB uses a Taylor rule for open economies in order to determine the interest rate. In the case of small and open economies, the inflationary pressures come from internal and external factors. We use a New Keynesian (NK) model with nominal rigidity and adaptive agents in order to study the alternatives of the CB in order to achieve its objectives. Our results show that a high level of credibility of the monetary authority and stable external conditions are necessary for the success of the policies promoted by the CB.