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Optimal Monetary Policy in an Open Economy

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  • Peter J. Stemp
  • Stephen J. Turnovsky

Abstract

This paper analyzes the optimal intertemporal tradeoff between inflation and output in an open economy under perfect foresight. The announcement of the optimal plan may, or may not, generate an initial jump in the exchange rate. That depends upon the real adjustment costs, which such unanticipated changes impose on the economy. In the case that such jumps occur, the question of time consistency of the optimal policy arises. A time consistent solution is obtained provided: (i) the policy maker is not too myopic; (ii) the adjustment costs associated with the jump in the exchange rate are of an appropriate form. The optimal monetary rule is derived and properties of this rule, as well as the overall optimal adjustment of the economy are discussed.

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Bibliographic Info

Paper provided by National Bureau of Economic Research, Inc in its series NBER Working Papers with number 2018.

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Date of creation: Sep 1986
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Publication status: published as Stemp, Peter J. Stemp and Stephen J. Turnovsky. "Optimal Monetary Policy inan Open Economy," European Economic Review, Vol. 31, No. 5, July 1987, pp. 1113-1135.
Handle: RePEc:nbr:nberwo:2018

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  1. Dornbusch, Rudiger, 1976. "Expectations and Exchange Rate Dynamics," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 84(6), pages 1161-76, December.
  2. Boyer, Russell S, 1978. "Optimal Foreign Exchange Market Intervention," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 86(6), pages 1045-55, December.
  3. Cox, W. Michael, 1980. "Unanticipated money, output, and prices in the small economy," Journal of Monetary Economics, Elsevier, Elsevier, vol. 6(3), pages 359-384, July.
  4. Kamien, Morton I. & Schwartz, Nancy L., 1971. "Sufficient conditions in optimal control theory," Journal of Economic Theory, Elsevier, Elsevier, vol. 3(2), pages 207-214, June.
  5. Turnovsky, Stephen J. & Brock, William A., 1980. "Time consistency and optimal government policies in perfect foresight equilibrium," Journal of Public Economics, Elsevier, Elsevier, vol. 13(2), pages 183-212, April.
  6. Kydland, Finn E & Prescott, Edward C, 1977. "Rules Rather Than Discretion: The Inconsistency of Optimal Plans," Journal of Political Economy, University of Chicago Press, University of Chicago Press, vol. 85(3), pages 473-91, June.
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Cited by:
  1. Reinhard Neck & Engelbert Dockner, 1995. "Commitment and coordination in a dynamic game model of international economic policy-making," Open Economies Review, Springer, Springer, vol. 6(1), pages 5-28, January.
  2. Turnovsky, Stephen J & Basar, Tamer & d'Orey, Vasco, 1988. "Dynamic Strategic Monetary Policies and Coordination in Interdependent Economies," American Economic Review, American Economic Association, American Economic Association, vol. 78(3), pages 341-61, June.

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