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Optimal Monetary Policy in an Open Economy under Asset Market Segmentation

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  • Rajesh Singh

    (Iowa State University)

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    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 Society for Economic Dynamics in its series 2013 Meeting Papers with number 103.

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    Date of creation: 2013
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    Handle: RePEc:red:sed013:103

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    1. Fernando Alvarez & Andrew Atkeson, 1996. "Money and Exchange Rates in the Grossman-Weiss-Rotemberg Model," NBER Working Papers 5678, National Bureau of Economic Research, Inc.
    2. Clarida, Richard & Gali, Jordi & Gertler, Mark, 2002. "A simple framework for international monetary policy analysis," Journal of Monetary Economics, Elsevier, vol. 49(5), pages 879-904, July.
    3. Rotemberg, Julio J, 1984. "A Monetary Equilibrium Model with Transactions Costs," Journal of Political Economy, University of Chicago Press, vol. 92(1), pages 40-58, February.
    4. 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.
    5. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Stabilization policy and the costs of dollarization," Proceedings, Federal Reserve Bank of Cleveland, pages 482-517.
    6. Chatterjee, Satyajit & Corbae, Dean, 1992. "Endogenous Market Participation and the General Equilibrium Value of Money," Journal of Political Economy, University of Chicago Press, vol. 100(3), pages 615-46, June.
    7. Singh, Rajesh & Lahiri, Amartya & Vegh, Carlos A, 2007. "Segmented Asset Markets and Optimal Exchange Rate Regimes," Staff General Research Papers 11446, Iowa State University, Department of Economics.
    8. 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.
    9. 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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