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Monetary Policy and Exchange Rate Volatility in a Small Open Economy

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  • Jordi Galí
  • Tommaso Monacelli
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    Abstract

    We lay out a small open economy version of the Calvo sticky price model, and show how the equilibrium dynamics can be reduced to a tractable canonical system in domestic inflation and the output gap. We employ this framework to analyze the macroeconomic implications of three alternative rule-based policy regimes for the small open economy: domestic inflation and CPI-based Taylor rules, and an exchange rate peg. We show that a key difference among these regimes lies in the relative amount of exchange rate volatility that they entail. We also discuss a special case for which domestic inflation targeting constitutes the optimal policy, and where a simple second order approximation to the utility of the representative consumer can be derived and used to evaluate the welfare losses associated with those suboptimal rules.

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    Bibliographic Info

    Paper provided by Barcelona Graduate School of Economics in its series Working Papers with number 11.

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    Date of creation: Dec 2003
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    Handle: RePEc:bge:wpaper:11

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    Related research

    Keywords: Small open economy; optimal monetary policy; sticky prices; exchange rate peg; exchange rate volatility;

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    References

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    1. Obstfeld, Maurice & Rogoff, Kenneth, 2000. "New directions for stochastic open economy models," Journal of International Economics, Elsevier, vol. 50(1), pages 117-153, February.
    2. Kaushik Mitra & James Bullard, . "Learning About Monetary Policy Rules," Discussion Papers, Department of Economics, University of York 00/41, Department of Economics, University of York.
    3. Robert Kollmann, 2001. "The exchange rate in a dynamic-optimizing business cycle model with nominal rigidities: a quantitative investigation," ULB Institutional Repository 2013/7630, ULB -- Universite Libre de Bruxelles.
    4. David K. Backus & Gregor W. Smith, 1992. "Consumption and Real Exchange Rates in Dynamic Exchange Economies with Nontraded Goods," Working Papers, New York University, Leonard N. Stern School of Business, Department of Economics 92-7, New York University, Leonard N. Stern School of Business, Department of Economics.
    5. Hau, Harald, 2000. "Real Exchange Rate Volatility and Economic Openness: Theory and Evidence," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2356, C.E.P.R. Discussion Papers.
    6. Gianluca Benigno & Pierpaolo Benigno, 2003. "Price Stability in Open Economies," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 70(4), pages 743-764, October.
    7. Obstfeld, Maurice & Rogoff, Kenneth, 1995. "Exchange Rate Dynamics Redux," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 103(3), pages 624-60, June.
    8. Betts, Caroline & Devereux, Michael B., 2000. "Exchange rate dynamics in a model of pricing-to-market," Journal of International Economics, Elsevier, vol. 50(1), pages 215-244, February.
    9. Benigno, Pierpaolo, 2001. "Optimal Monetary Policy in a Currency Area," CEPR Discussion Papers, C.E.P.R. Discussion Papers 2755, C.E.P.R. Discussion Papers.
    10. Betts, Caroline & Devereux, Michael B., 1996. "The exchange rate in a model of pricing-to-market," European Economic Review, Elsevier, vol. 40(3-5), pages 1007-1021, April.
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    Cited by:
    1. Loungani, Prakash & Razin, Assaf, 2005. "Globalization and Disinflation: The Efficiency Channel," CEPR Discussion Papers, C.E.P.R. Discussion Papers 4895, C.E.P.R. Discussion Papers.
    2. Wolfram Berger, 2010. "International Policy Coordination and Simple Monetary Policy Rules," Swiss Journal of Economics and Statistics (SJES), Swiss Society of Economics and Statistics (SSES), Swiss Society of Economics and Statistics (SSES), vol. 146(II), pages 451-479, June.
    3. Razin, Assaf, 2004. "Aggregate Supply and Potential Output," CEPR Discussion Papers, C.E.P.R. Discussion Papers 4295, C.E.P.R. Discussion Papers.
    4. Berger, Wolfram, 2006. "The choice between fixed and flexible exchange rates: Which is best for a small open economy?," Journal of Policy Modeling, Elsevier, Elsevier, vol. 28(4), pages 371-385, May.
    5. Juan Pablo Medina & Ruy Lama, 2004. "Simple Monetary Policy Rules for Developing Countries," Econometric Society 2004 Latin American Meetings, Econometric Society 248, Econometric Society.
    6. Corsetti, Giancarlo, 2007. "New Open Economy Macroeconomics," CEPR Discussion Papers, C.E.P.R. Discussion Papers 6578, C.E.P.R. Discussion Papers.
    7. Jose De Gregorio & Andrea Tokman R., 2004. "Overcoming Fear of Floating: Exchange Rate Policies in Chile," Working Papers Central Bank of Chile, Central Bank of Chile 302, Central Bank of Chile.
    8. Park, Hyun, 2013. "Do habits generate endogenous fluctuations in a growing economy?," International Review of Economics & Finance, Elsevier, Elsevier, vol. 27(C), pages 54-68.
    9. Assaf Razin & Alon Binyamini, 2007. "Flattening of the Short-run Trade-off between Inflation and Domestic Activity: The Analytics of the Effects of Globalization," Kiel Working Papers 1363, Kiel Institute for the World Economy.

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