Estimating shadow policy rates in a small open economy and the role of foreign factors

Abstract

Shadow monetary policy rates (SMPRs) are useful to evaluate the monetary stance when interest rates are at their lower bounds and unconventional policies are implemented. We present a methodology to estimate an SMPR for the case of a small open economy based on a structural dynamic factor model, which allows to consider the impact of foreign monetary conditions on domestic ones and identify their respective role for the domestic monetary stance. An application to Chile shows that unconventional policies drove the estimated domestic SMPR to negative levels during crisis episodes, with an important role for foreign factors. Alternative specifications that neglect small open economy dimensions yield noisy and less robust results, and imply very different conclusions about the level and drivers of the estimated SMPR.