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Monetary Policy, Real Exchange Rate, and the Current Account in a Small Open Economy

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Claudio Soto

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Abstract

Using a sticky price model for small open economy this paper compares the consequences of two alternative monetary policies over a set of variables. The baseline case assumes a policy rule for the Central Bank that has inflation forecast and output as a target. The alternative policy is a rule that also includes a target for the real exchange rate. The inclusion of a target for the real exchange rate in the policy reaction function of the Central Bank could be important if the monetary authority is concerned about fluctuations in the current account. The results show that the alternative policy can help to reduce the volatility of the external accounts and in some case it can also help to reduce the volatility of the output gap. However, this policy introduces more volatility in inflation and it also makes the convergence of this variable to its steady state level slower.

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Paper provided by Central Bank of Chile in its series Working Papers Central Bank of Chile with number 253.

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Date of creation: Dec 2003
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Handle: RePEc:chb:bcchwp:253

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  1. Richard Clarida & Jordi Gali & Mark Gertler, 1999. "The Science of Monetary Policy: A New Keynesian Perspective," Journal of Economic Literature, American Economic Association, vol. 37(4), pages 1661-1707, December. [Downloadable!] (restricted)
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  2. Svensson, Lars E.O., 1998. "Open-Economy Inflation Targeting," Seminar Papers 638, Stockholm University, Institute for International Economic Studies. [Downloadable!]
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  3. Laurence Ball, 1998. "Policy Rules for Open Economies," NBER Working Papers 6760, National Bureau of Economic Research, Inc. [Downloadable!] (restricted)
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  4. Eric Parrado, 2004. "Inflation Targeting and Exchange Rate Rules in an Open Economy," IMF Working Papers 04/21, International Monetary Fund. [Downloadable!]
  5. Jordi Gali & Tommaso Monacelli, 1999. "Optimal Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Boston College Working Papers in Economics 438, Boston College Department of Economics, revised 15 Nov 1999. [Downloadable!]
  6. David K. Backus & Patrick J. Kehoe & Finn E. Kydland, 1991. "International real business cycles," Staff Report 146, Federal Reserve Bank of Minneapolis. [Downloadable!]
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  7. Mervyn King, 1999. "Challenges for monetary policy : new and old," Proceedings, Federal Reserve Bank of Kansas City, pages 11-57. [Downloadable!]
  8. Juan Pablo Medina & Rodrigo Valdés, 2000. "Optimal Monetary Policy Rules when the Current Account Matters," Working Papers Central Bank of Chile 77, Central Bank of Chile. [Downloadable!]
  9. Svensson, L.E.O., 1992. "Why Exchange Rate Bands? Monetary Independence in Spite of Fixed Exchange Rates," Papers 521, Stockholm - International Economic Studies.
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