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Optimal Devaluations

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  • Constantino Hevia

    (World Bank)

Abstract

We analyze optimal policy in a simple small open economy model with price setting frictions. In particular, we study the optimal response of the nominal exchange rate following a terms of trade shock. We depart from the New Keynesian literature in that we explicitly model internationally traded commodities as intermediate inputs in the production of local final goods and assume that the small open economy takes this price as given. This modification is not only in line with the long standing tradition of small open economy models, but also drastically changes the optimal movements in the exchange rate. We perform our analysis in the tradition of optimal dynamic Ramsey problems, so we characterize optimal allocation and the government policies that implement it. We show that, while we can derive general second best policy principles, the exact way the nominal exchange rate ought to comove with the terms of trade depends on specific details of the model.

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Paper provided by Society for Economic Dynamics in its series 2011 Meeting Papers with number 1070.

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Date of creation: 2011
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Handle: RePEc:red:sed011:1070

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Citations

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Cited by:
  1. Adao, Bernardino & Correia, Maria Isabel Horta & Teles, Pedro, 2006. "On the Relevance of Exchange Rate Regimes for Stabilization Policy," CEPR Discussion Papers 5797, C.E.P.R. Discussion Papers.
  2. Oleg Itskhoki & Gita Gopinath & Emmanuel Farhi, 2011. "Fiscal Devaluations," 2011 Meeting Papers 406, Society for Economic Dynamics.
  3. Hevia, Constantino & Nicolini, Juan Pablo, 2009. "Optimal devaluations," Policy Research Working Paper Series 4926, The World Bank.
  4. Dmitriev, Mikhail & Hoddenbagh, Jonathan, 2012. "Price Stability In Small Open Economies," MPRA Paper 46132, University Library of Munich, Germany, revised Feb 2013.
  5. Tommaso Monacelli, 2012. "Is Monetary Policy in an Open Economy Fundamentally Different?," Working Papers 449, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  6. Bianca De Paoli, 2004. "Monetary policy and welfare in a small open economy," LSE Research Online Documents on Economics 19950, London School of Economics and Political Science, LSE Library.
  7. Luis Cat�o & Roberto Chang, 2013. "Monetary Rules for Commodity Traders," IMF Economic Review, Palgrave Macmillan, vol. 61(1), pages 52-91, April.
  8. Tommaso Monacelli, 2013. "Is Monetary Policy in an Open Economy Fundamentally Different?," IMF Economic Review, Palgrave Macmillan, vol. 61(1), pages 6-21, April.
  9. Jacek Rothert, 2012. "Productivity or Demand? Identifying Sources of Fluctuations in Small Open Economies," 2012 Meeting Papers 187, Society for Economic Dynamics.

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