Growth Shocks under Alternative Macro Regimes in a Developing Economy

Abstract A key challenge facing most developing economies today is how to simultaneously maintain monetary independence, exchange rate stability, and financial integration, subject to the constraints imposed by the impossible trinity. In this paper, we contribute to the literature by examining and comparing alternative macroeconomic policy choices for a developing economy with growth shocks. To that end, we introduce a three-sector “almost small” open economy macroeconomic model, and calibrate this model to proxy the China in 2005 when it made the transition from being an economy that was bounded by the impossible trinity. We design two alternative macroeconomic policy regimes and apply the calibrated model to analyze both the short-run and the long-run responses to several domestic and external growth shocks, which appeared important for a developing economy like China during its economic reform period in the 2000s. The model simulation shows that most growth shocks cause an expansion in the real GDP level. Moreover, greater flexibility in the exchange rate allows the central bank to conduct independent monetary policy, the benefit from which increases as financial capital becomes more internationally mobile. Our findings draw policy implication for those developing countries considering alternative macroeconomic policy regimes to achieve sustainable economic growth.