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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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  • Jääskelä, Jarkko P. & Kulish, Mariano, 2010. "The butterfly effect of small open economies," Journal of Economic Dynamics and Control, Elsevier, vol. 34(7), pages 1295-1304, July.
    • Handle: RePEc:eee:dyncon:v:34:y:2010:i:7:p:1295-1304
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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. Kulish, Mariano & Rees, Daniel, 2011. "The yield curve in a small open economy," Journal of International Economics, Elsevier, vol. 85(2), pages 268-279.
    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.
    4. 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.

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    More about this item

    Keywords

    Indeterminacy Small open economy Rational expectations;

    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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