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Optimal Monetary Policy and Exchange Rate Volatility in a Small Open Economy

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  • Jordi Gali

    ()
    (Universitat Pompeu Fabra)

  • Tommaso Monacelli

    ()
    (Boston College)

Abstract

We lay out a tractable small open economy version of the canonical sticky price model, and use it as a framework to study the properties of three alternative monetary regimes: (a) optimal monetary policy, (b) a Taylor rule, and (c) an exchange rate peg. Several interesting results emerge from our analysis. First, the optimal policy is shown to entail a positive correlation between domestic and world interest rates. That doesnÃt prevent sizable fluctuations of nominal and real exchange rates from occurring, though the implied volatility of those variables is much smaller than the empirical one. Second, a Taylor rule generally leads to excess volatility of nominal variables, and excess smoothness of real variables, relative to the optimal policy. Finally, we show that a pure exchange rate peg causes the equilibrium to be indeterminate and may thus be a source of macroeconomic instability.

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Bibliographic Info

Paper provided by Boston College Department of Economics in its series Boston College Working Papers in Economics with number 438.

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Length: 34 pages
Date of creation: 15 Jan 1999
Date of revision: 15 Nov 1999
Handle: RePEc:boc:bocoec:438

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Keywords: small open economy; optimal monetary policy; sticky prices; Taylor rule;

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References

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  1. Benhabib, Jess & Schmitt-Grohé, Stephanie & Uribe, Martín, 1999. "The Perils of Taylor Rules," CEPR Discussion Papers 2314, C.E.P.R. Discussion Papers.
  2. Lane, P, 1999. "The New Open Economy Macroeconomics: A Survey," Trinity Economics Papers 993, Trinity College Dublin, Department of Economics.
  3. Maurice Obstfeld & Kenneth Rogoff, 1994. "Exchange Rate Dynamics Redux," NBER Working Papers 4693, National Bureau of Economic Research, Inc.
  4. Tommaso Monacelli, 1999. "Into the Mussa Puzzle: Monetary Policy Regimes and the Real Exchange Rate in a Small Open Economy," Boston College Working Papers in Economics 437, Boston College Department of Economics, revised 15 Sep 2000.
  5. Orphanides, Athanasios, 2000. "The quest for prosperity without inflation," Working Paper Series 0015, European Central Bank.
  6. Jordi Galí & Mark Gertler, 1998. "Inflation dynamics: A structural econometric analysis," Economics Working Papers 341, Department of Economics and Business, Universitat Pompeu Fabra.
  7. David Backus & Patrick J. Kehoe & Finn E. Kydland, 1993. "International Business Cycles: Theory and Evidence," NBER Working Papers 4493, National Bureau of Economic Research, Inc.
  8. Philippe Bacchetta & Eric van Wincoop, 1998. "Does exchange rate stability increase trade and capital flows?," Research Paper 9818, Federal Reserve Bank of New York.
  9. Richard Clarida & Jordi Gali & Mark Gertler, 1998. "Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory," NBER Working Papers 6442, National Bureau of Economic Research, Inc.
  10. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  11. Kaushik Mitra & James Bullard, . "Learning About Monetary Policy Rules," Discussion Papers 00/41, Department of Economics, University of York.
  12. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  13. 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.
  14. Giancarlo Corsetti & Paolo Pesenti, 1997. "Welfare and Macroeconomic Interdependence," NBER Working Papers 6307, National Bureau of Economic Research, Inc.
  15. Maurice Obstfeld & Kenneth Rogoff, 2000. "New Directions for Stochastic Open Economy Models," International Finance 0004002, EconWPA.
  16. Clarida, Richard & Gali, Jordi & Gertler, Mark, 1998. "Monetary policy rules in practice Some international evidence," European Economic Review, Elsevier, vol. 42(6), pages 1033-1067, June.
  17. 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.
  18. Mark Gertler & Jordi Gali & Richard Clarida, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December.
  19. V. V. Chari & Patrick J. Kehoe & Ellen R. McGrattan, 1997. "Monetary Shocks and Real Exchange Rates in Sticky Price Models of International Business Cycles," NBER Working Papers 5876, National Bureau of Economic Research, Inc.
  20. Michael B. Devereux & Charles Engel, 1998. "Fixed vs. Floating Exchange Rates: How Price Setting Affects the Optimal Choice of Exchange-Rate Regime," NBER Working Papers 6867, National Bureau of Economic Research, Inc.
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