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Overoptimism, Boom-bust Cycles, And Monetary Policy In Small Open Economies

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Executive Summary

This paper analyzes boom-bust cycles in emerging market economies triggered by miss-perception about future productivity. Using a small open economy DSGE model, the authors show that non-materialized news about future productivity improvements (i.e. overoptimism) generate boom-bust cycles that replicate the stylized facts of several emerging economies during the 1990s. They report simulation results for a boom-bust cycle under alternative monetary policy rules. In this paper, they show that if the central bank tries to stabilize output, there would be a large real appreciation of the currency and a deep contraction in the tradable goods sector.

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