The Welfare Effects of Inflation Volatility and Institutions : Implications for Emerging Market Economies

Using a micro-foundation based monetary Small Open Economy (SOE) model of McCandless (2008) with a cash-in-advance constraint, a capital adjustment cost, foreign bonds, and a trade sector, the study quantifies the welfare implications under two policy scenarios: (a) a reduction in inflation volatility and (b) an improvement in institutions. The monetary small open economy model is calibrated using quarterly data from 1989 to 2006 for an emerging market economy, Mexico, a country that, by the study’s measure has poor financial institutions and moderately high inflation volatility. The results of the model suggest that decreasing inflation volatility leads to about 8 percent increase in welfare, at most, while improving institutions leads to an increase in welfare by about 10 percent, at most