This paper develops a Dynamic Stochastic General Equilibrium (DSGE) model with a
financial accelerator which captures key features of low-income countries (LICs). The
predominance of supply shocks in LICs poses distinct challenges for policymakers, given the
negative correlation between inflation and the output gap in the case of supply shocks. Our
results suggest that: (1) in the face of a supply-side shock, the most desirable interest rate rule
involves simply targeting current inflation and smoothing the policy interest rate; and (2)
ignoring financial frictions when evaluating policy rules can be particularly problematic in
LICs, where financial frictions loom especially large.
This paper examines how durable goods and financial frictions shape the business cycle of a small open economy subject to shocks to trend and transitory shocks. In the data, nondurable consumption is not as volatile as income for both developed and emerging market economies. The simulation of the model implies that shocks to trend play a less important role than previously documented. Financial frictions improve the ability of the model to match some key business cycle properties of emerging economies. A countercyclical borrowing premium interacts with the nature of durable goods delivering highly volatile consumption and very countercyclical net exports.