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Price Stability In Small Open Economies

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  • Dmitriev, Mikhail
  • Hoddenbagh, Jonathan

Abstract

We study the conduct of monetary policy in a continuum of small open economies. We solve the model globally in closed form without restricting the elasticity of substitution between home and foreign goods to one. Using this global closed-form solution, we give an exact characterization of optimal monetary policy and welfare with and without international policy cooperation. We consider the cases of internationally complete asset markets and financial autarky, producer currency pricing and local currency pricing. Under producer currency pricing, it is always optimal to mimic the flexible-price equilibrium through a policy of price stability. Under local currency pricing, policy should fix the exchange rate. Even if substitutability differs from one, the continuum of small open economies implies that the share of each country's output in the world consumption basket (and therefore the impact of the country's monopoly power) is negligible. This removes the incentive to deviate from price stability under producer currency pricing or a fixed exchange rate under local currency pricing. There are no gains from international monetary cooperation in all cases examined. Our results stand in contrast to those in the literature on optimal monetary policy for large open economies, where strategic interactions drive optimal policy away from price stability or fixed exchange rates, and gains from cooperation are present, when substitutability differs from one.

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Bibliographic Info

Paper provided by University Library of Munich, Germany in its series MPRA Paper with number 46118.

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Date of creation: Nov 2012
Date of revision: Feb 2013
Handle: RePEc:pra:mprapa:46118

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Keywords: Open economy macroeconomics; Optimal monetary policy; Price stability.;

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  1. Constantino Hevia & Juan Pablo Nicolini, 2013. "Optimal Devaluations," IMF Economic Review, Palgrave Macmillan, Palgrave Macmillan, vol. 61(1), pages 22-51, April.
  2. Marvin Goodfriend & Robert G. King, 2001. "The case for price stability," Working Paper, Federal Reserve Bank of Richmond 01-02, Federal Reserve Bank of Richmond.
  3. Michael B. Devereux & Charles Engel, 2003. "Monetary Policy in the Open Economy Revisited: Price Setting and Exchange-Rate Flexibility," Review of Economic Studies, Wiley Blackwell, Wiley Blackwell, vol. 70(4), pages 765-783, October.
  4. Obstfeld, Maurice & Rogoff, Kenneth, 1999. "New Directions for Stochastic Open Economy Models," Center for International and Development Economics Research, Working Paper Series, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkele qt5pf7g8sh, Center for International and Development Economics Research, Institute for Business and Economic Research, UC Berkeley.
  5. Benigno, Gianluca & Benigno, Pierpaolo, 2006. "Designing targeting rules for international monetary policy cooperation," Journal of Monetary Economics, Elsevier, Elsevier, vol. 53(3), pages 473-506, April.
  6. Aoki, Kosuke, 2001. "Optimal monetary policy responses to relative-price changes," Journal of Monetary Economics, Elsevier, Elsevier, vol. 48(1), pages 55-80, August.
  7. Woodford, Michael, 2000. "Monetary Policy in a World without Money," International Finance, Wiley Blackwell, Wiley Blackwell, vol. 3(2), pages 229-60, July.
  8. Bianca De Paoli, 2009. "Monetary Policy Under Alterative Asset Market Structures: the Case of a Small Open Economy," CEP Discussion Papers, Centre for Economic Performance, LSE dp0923, Centre for Economic Performance, LSE.
  9. Giancarlo Corsetti & Paolo Pesenti, 2001. "International dimensions of optimal monetary policy," Staff Reports, Federal Reserve Bank of New York 124, Federal Reserve Bank of New York.
  10. Ester Faia & Tommaso Monacelli, 2008. "Optimal Monetary Policy in a Small Open Economy with Home Bias," Journal of Money, Credit and Banking, Blackwell Publishing, Blackwell Publishing, vol. 40(4), pages 721-750, 06.
  11. Gianluca Benigno & Pierpaolo Benigno, 2003. "Price Stability in Open Economies," Review of Economic Studies, Oxford University Press, vol. 70(4), pages 743-764.
  12. Dmitriev, Mikhail & Hoddenbagh, Jonathan, 2012. "The optimal design of a fiscal union," MPRA Paper 46007, University Library of Munich, Germany, revised Apr 2013.
  13. 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.
  14. Cole, Harold L. & Obstfeld, Maurice, 1991. "Commodity trade and international risk sharing : How much do financial markets matter?," Journal of Monetary Economics, Elsevier, Elsevier, vol. 28(1), pages 3-24, August.
  15. Jordi Gal� & Tommaso Monacelli, 2005. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Review of Economic Studies, Oxford University Press, vol. 72(3), pages 707-734.
  16. Giancarlo Corsetti & Paolo Pesenti, 2001. "Welfare And Macroeconomic Interdependence," The Quarterly Journal of Economics, MIT Press, MIT Press, vol. 116(2), pages 421-445, May.
  17. Matthew B. Canzoneri & Dale W. Henderson, 1991. "Monetary Policy in Interdependent Economies: A Game-Theoretic Approach," MIT Press Books, The MIT Press, The MIT Press, edition 1, volume 1, number 0262031787, December.
  18. Monacelli, Tommaso, 2012. "Is Monetary Policy in an Open Economy Fundamentally Different?," CEPR Discussion Papers, C.E.P.R. Discussion Papers 9087, C.E.P.R. Discussion Papers.
  19. Rogoff, Kenneth, 1985. "Can international monetary policy cooperation be counterproductive?," Journal of International Economics, Elsevier, Elsevier, vol. 18(3-4), pages 199-217, May.
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Cited by:
  1. Jonathan Hoddenbagh & Mikhail Dmitriev, 2013. "The Optimal Design of a Fiscal Union," 2013 Papers, Job Market Papers pho497, Job Market Papers.
  2. Matteo Cacciatore, 2013. "Trade, Unemployment, and Monetary Policy," 2013 Meeting Papers, Society for Economic Dynamics 724, Society for Economic Dynamics.

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