Institutional Quality, the Cyclicality of Monetary Policy and Macroeconomic Volatility’, manuscript

In contrast to industrialized countries, emerging market economies are characterized by pro-or acyclical monetary policies and high output volatility. This paper argues that those facts can be related to a long-run feature of the economy- namely, its institutional quality (IQL). The paper presents evidence that supports the link between an index of IQL (law and order, government stability, investment profile, etc.), and (i) the cyclicality of monetary policy, and (ii) the volatilities of output and the nominal interest rate. In a DSGE model, foreign investors that choose a portfolio of direct investment and lending to domestic agents, face a probability of partial confiscation which works as a proxy that captures IQL. The economy is hit by external shocks to demand for home goods and productivity shocks while its central bank seeks to stabilize inflation and output. In the long run, a lower IQL tends to discourage external liabilities. If there is a positive external demand shock, we observe an increase in output and real appreciation. The latter operates through two opposite channels. First, it directly increases the opportunity cost of leisure generating incentives to expand labor supply. Second, it reduces the real value of the debt denominated in foreign currency whic