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Optimal Monetary Policy in an Open Economy under Asset Market Segmentation

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  • Singh, Rajesh
  • Lahiri, Amartya
  • Vegh, Carlos A

Abstract

This paper studies optimal monetary policy in a small open economy under flexible prices. The paper's key innovation is to analyze this question in the context of environments where only a fraction of agents participate in asset market transactions (i.e., asset markets are segmented). �In this environment, we study three rules: the optimal state contingent monetary policy; the optimal non-state contingent money growth rule; and the optimal non-state contingent devaluation rate rule. �We compare welfare and the volatility of macro aggegates like consumption, exchange rate, and money under the different rules. �One of our key findings is that amongst non-state contingent rules, policies targeting the exchange rate are, in general, welfare dominated by policies which target monetary aggregates. �Crucially, we find that fixed exchange rates are almost never optimal. �On the other hand, under some conditions, a non-state contingent rule like a fixed money rule can even implement the first-best allocation.

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Bibliographic Info

Paper provided by Iowa State University, Department of Economics in its series Staff General Research Papers with number 35649.

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Date of creation: 13 Nov 2012
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Handle: RePEc:isu:genres:35649

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Postal: Iowa State University, Dept. of Economics, 260 Heady Hall, Ames, IA 50011-1070
Phone: +1 515.294.6741
Fax: +1 515.294.0221
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Web page: http://www.econ.iastate.edu
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Keywords: Optimal Monetary Policy; Asset Market Segmentation;

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  1. Luis Felipe Céspedes & Roberto Chang & Andrés Velasco, 2004. "Balance Sheets and Exchange Rate Policy," American Economic Review, American Economic Association, vol. 94(4), pages 1183-1193, September.
  2. Stephanie Schmitt-Grohe & Martin Uribe, 2000. "Stabilization Policy and the Costs of Dollarization," Departmental Working Papers 200006, Rutgers University, Department of Economics.
  3. Julio J. Rotemberg, 1982. "A Monetary Equilibrium Model with Transactions Costs," NBER Working Papers 0978, National Bureau of Economic Research, Inc.
  4. Lahiri, Amartya & Singh, Rajesh & Vegh, Carlos, 2007. "Segmented asset markets and optimal exchange rate regimes," Journal of International Economics, Elsevier, vol. 72(1), pages 1-21, May.
  5. 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.
  6. Richard Clarida & Jordi Gali & Mark Gertler, 2002. "A Simple Framework for International Monetary Policy Analysis," NBER Working Papers 8870, National Bureau of Economic Research, Inc.
  7. Leslie Lipschitz, 1978. "Exchange Rate Policies for Developing Countries: Some Simple Arguments for Intervention (Les politiques de taux de change et les pays en voie de développement: quelques arguments simples en faveur ," IMF Staff Papers, Palgrave Macmillan, vol. 25(4), pages 650-675, December.
  8. Alvarez, Fernando & Atkeson, Andrew, 1997. "Money and exchange rates in the Grossman-Weiss-Rotemberg model," Journal of Monetary Economics, Elsevier, vol. 40(3), pages 619-640, December.
  9. Chatterjee, S. & Corbae, D., 1990. "Endogenous Market Participation and the General Equelibrium Value of Money," Working Papers 90-30a, University of Iowa, Department of Economics.
  10. Casey B. Mulligan & Xavier Sala-i-Martin, 2000. "Extensive Margins and the Demand for Money at Low Interest Rates," Journal of Political Economy, University of Chicago Press, vol. 108(5), pages 961-991, October.
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