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Monetary Policy and Exchange Rate Volatility in a Small Open Economy

  • Jordi Galí
  • Tommaso Monacelli

We lay out a small open economy version of the Calvo sticky price model, and show how the equilibrium dynamics can be reduced to a simple representation in domestic inflation and the output gap. We use the resulting framework to analyse the macroeconomic implications of three alternative rule-based policy regimes for the small open economy: domestic inflation and CPI-based Taylor rules, and an exchange rate peg. We show that a key difference among these regimes lies in the relative amount of exchange rate volatility that they entail. We also discuss a special case for which domestic inflation targeting constitutes the optimal policy, and where a simple second order approximation to the utility of the representative consumer can be derived and used to evaluate the welfare losses associated with the suboptimal rules. Copyright 2005, Wiley-Blackwell.

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File URL: http://hdl.handle.net/10.1111/j.1467-937X.2005.00349.x
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Article provided by Oxford University Press in its journal The Review of Economic Studies.

Volume (Year): 72 (2005)
Issue (Month): 3 ()
Pages: 707-734

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Handle: RePEc:oup:restud:v:72:y:2005:i:3:p:707-734
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