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The butterfly effect of small open economies

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  • Jääskelä, Jarkko P.
  • Kulish, Mariano

Abstract

The rational expectations equilibrium of a small open economy can be subject to indeterminacy if foreign monetary policy does not satisfy the Taylor principle. We study the implications of foreign induced indeterminacy in the two-country version of the sticky-price small open economy model. Our main finding is that 'smallness' is a property of the unique rational expectations equilibrium of the large economy, and not a general property of the small open economy model. If the large economy fails to anchor expectations, shocks to the small economy can affect the large one. This form of indeterminacy gives rise to a 'butterfly effect'. Additional assumptions are required to preserve the 'smallness' of the small economy.

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Article provided by Elsevier in its journal Journal of Economic Dynamics and Control.

Volume (Year): 34 (2010)
Issue (Month): 7 (July)
Pages: 1295-1304

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Handle: RePEc:eee:dyncon:v:34:y:2010:i:7:p:1295-1304
Contact details of provider: Web page: http://www.elsevier.com/locate/jedc

Keywords: Indeterminacy Small open economy Rational expectations;

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Find related papers by JEL classification:
  • E30 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - General (includes Measurement and Data)
  • E32 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles - - - Business Fluctuations; Cycles
  • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
  • E58 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Central Banks and Their Policies
  • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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Cited by:

  1. Blake, Andrew P & Markovic, Bojan, 2008. "The conduct of global monetary policy and domestic stability," Bank of England working papers 353, Bank of England.
  2. Jones, Callum & Kulish, Mariano, 2013. "Long-term interest rates, risk premia and unconventional monetary policy," Journal of Economic Dynamics and Control, Elsevier, vol. 37(12), pages 2547-2561.
  3. Jääskelä, Jarkko P. & Jennings, David, 2011. "Monetary policy and the exchange rate: Evaluation of VAR models," Journal of International Money and Finance, Elsevier, vol. 30(7), pages 1358-1374.

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