The IMF Working Papers series is designed to make IMF staff research available to a wide audience. Almost 300 Working Papers are released each year, covering a wide range of theoretical and analytical topics, including balance of payments, monetary and fiscal issues, global liquidity, and national and international economic developments.
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.