Alternative Policy Rules in a Model with Endogenous Sudden Stops: ∗ † Gianluca Benigno London School of Economics Christopher Otrok University of Virginia Alessandro Rebucci International Monetary Fund Eric Young University of Virginia May 6, 2007 Preliminary and incomplete. Comments welcome. Abstract We introduce nominal rigidities and monetary policy in simple two-good endowment economy with an occasionally binding liquidity constraint as in Mendoza (2002). We then compare the performance of alternative policy rules, under both flexible and sticky prices, against the benchmark of estimated policy rule from Brazil since the 1994 stabilization. We report two main results under flexible prices in this version of the paper. First, we find that nonlinear rules generally dominate linear ones; in particular, a nonlinear rule that responds only to large deviations from the steady state of the relative price of non-tradable goods achieves the highest welfare level. Second, we find that the estimated rule responds with the wrong sign when the price of nontradables moves away from the steady state, exacerbating its volatility. That is, the estimated rule destabilizes the economy, which we interpret as the manifestation of the procyclical nature of policy typical of many emerging market economies. ∗ We are grateful to Enrique Mendoza and Martin Uribe for very helpful discussions, Andre Minella at the central bank of Brazil for help with the Brazilian data, and to Huigang Chen for outstanding support with Matlab programming. The views expressed in this paper are exclusively those of the authors and not those of the International Monetary Fund. The usual disclaimer applies. † Correspondence: Alessandro Rebucci, IMF Research Department, 700 19th St., NW, Washington DC, USA. Email: ARebucci@imf.org.