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Openness and optimal monetary policy

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  • Lombardo, Giovanni
  • Ravenna, Federico

Abstract

We show that the composition of international trade has important implications for the optimal volatility of the exchange rate, above and beyond the size of trade flows. Using an analytically tractable small open economy model, we characterize the impact of the trade composition on the policy trade-off and on the role played by the exchange rate in correcting for price misalignments. Contrary to models where openness can be summarized by the degree of home bias, we find that openness can be a poor proxy of the welfare impact of alternative monetary policies. Using input–output data for 25 countries we document substantial differences in the import and non-tradable content of final demand components, and in the role played by imported inputs in domestic production. The estimates are used in a richer small-open-economy DSGE model to quantify the loss from an exchange rate peg relative to the Ramsey policy conditional on the composition of imports. We find that the main determinant of the losses is the share of non-traded goods in final demand.

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Bibliographic Info

Article provided by Elsevier in its journal Journal of International Economics.

Volume (Year): 93 (2014)
Issue (Month): 1 ()
Pages: 153-172

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Handle: RePEc:eee:inecon:v:93:y:2014:i:1:p:153-172

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Web page: http://www.elsevier.com/locate/inca/505552

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Keywords: International trade; Exchange rate regimes; Non-tradable goods; Optimal policy;

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Cited by:
  1. Lombardo, Giovanni & Ravenna, Federico, 2012. "The size of the tradable and non-tradable sectors: Evidence from input–output tables for 25 countries," Economics Letters, Elsevier, vol. 116(3), pages 558-561.

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