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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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Cited by:
  1. Bianca De Paoli, 2004. "Monetary policy and welfare in a small open economy," LSE Research Online Documents on Economics, London School of Economics and Political Science, LSE Library 19950, London School of Economics and Political Science, LSE Library.
  2. Luis Cat�o & Roberto Chang, 2013. "Monetary Rules for Commodity Traders," IMF Economic Review, Palgrave Macmillan, Palgrave Macmillan, vol. 61(1), pages 52-91, April.
  3. Hevia, Constantino & Nicolini, Juan Pablo, 2009. "Optimal devaluations," Policy Research Working Paper Series 4926, The World Bank.
  4. Emmanuel Farhi & Gita Gopinath & Oleg Itskhoki, 2012. "Fiscal devaluations," Working Papers, Federal Reserve Bank of Boston 12-10, Federal Reserve Bank of Boston.
  5. Jacek Rothert, 2012. "Productivity or Demand? Identifying Sources of Fluctuations in Small Open Economies," 2012 Meeting Papers, Society for Economic Dynamics 187, Society for Economic Dynamics.
  6. Bernardino Adão & Isabel Horta Correia & Pedro Teles, 2006. "On the Relevance of Exchange Rate Regimes for Stabilization Policy," Working Papers, Banco de Portugal, Economics and Research Department w200616, Banco de Portugal, Economics and Research Department.
  7. Tommaso Monacelli, 2013. "Is Monetary Policy in an Open Economy Fundamentally Different?," IMF Economic Review, Palgrave Macmillan, Palgrave Macmillan, vol. 61(1), pages 6-21, April.
  8. Tommaso Monacelli, 2012. "Is Monetary Policy in an Open Economy Fundamentally Different?," Working Papers 449, IGIER (Innocenzo Gasparini Institute for Economic Research), Bocconi University.
  9. Dmitriev, Mikhail & Hoddenbagh, Jonathan, 2012. "Price Stability In Small Open Economies," MPRA Paper 46118, University Library of Munich, Germany, revised Feb 2013.

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