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Optimal Monetary Policy in a Small, Open Economy: A General Equilibrium Analysis

In: Monetary Policy: Rules and Transmission Mechanisms

  • Charles T. Carlstrom

    (Federal Reserve Bank of Cleveland)

  • Timothy S. Fuerst

    (Bowling Green State University)

This paper uses a small open economy model to address two outstanding issues in monetary policy: (1) what restrictions on the policy rule ensure that the central bank does not introduce real indeterminacy into the economy, and (2) what is the optimal long run rate of inflation. The small open economy model provides unique insights on both fronts. In the case of determinacy issues, the model’s simplicity makes the analysis remarkably transparent. As for long run inflation rates, a small open economy takes as given the foreign nominal interest rate. To the extent that this rate distorts domestic behavior, there is a role for positive domestic nominal rates (in contrast to Friedman’s celebrated optimum quantity of money). This motivation arises naturally in the setting of a small open economy.

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This chapter was published in: Norman Loayza & Klaus Schmidt-Hebbel & Norman Loayza (Series Editor) & Klaus Schmidt-Hebbel (Series Editor) (ed.) Monetary Policy: Rules and Transmission Mechanisms, , chapter 10, pages 275-298, 2002.
This item is provided by Central Bank of Chile in its series Central Banking, Analysis, and Economic Policies Book Series with number v04c10pp275-298.
Handle: RePEc:chb:bcchsb:v04c10pp275-298
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  1. Stephanie Schmitt-Grohe & Jess Benhabib & Martin Uribe, 2001. "Monetary Policy and Multiple Equilibria," American Economic Review, American Economic Association, vol. 91(1), pages 167-186, March.
  2. V.V. Chari & Lawrence J. Christiano & Patrick J. Kehoe, 1993. "Optimality of the Friedman rule in economies with distorting taxes," Staff Report 158, Federal Reserve Bank of Minneapolis.
  3. Charles T. Carlstrom & Timothy S. Fuerst, 2001. "Real Indeterminacy in Monetary Models with Nominal Interest Rate Distortions," Review of Economic Dynamics, Elsevier for the Society for Economic Dynamics, vol. 4(4), pages 767-789, October.
  4. Lucas, Robert Jr., 1990. "Liquidity and interest rates," Journal of Economic Theory, Elsevier, vol. 50(2), pages 237-264, April.
  5. Timothy J. Kehoe & David K. Levine & Michael Woodford, 1990. "The optimum quantity of money revisited," Working Papers 404, Federal Reserve Bank of Minneapolis.
  6. Robert G. King & Alexander L. Wolman, 1996. "Inflation targeting in a St. Louis model of the 21st century," Review, Federal Reserve Bank of St. Louis, issue May, pages 83-107.
  7. Grilli, Vittorio & Roubini, Nouriel, 1992. "Liquidity and exchange rates," Journal of International Economics, Elsevier, vol. 32(3-4), pages 339-352, May.
  8. Mendoza, Enrique G, 1991. "Real Business Cycles in a Small Open Economy," American Economic Review, American Economic Association, vol. 81(4), pages 797-818, September.
  9. Fuerst, Timothy S., 1992. "Liquidity, loanable funds, and real activity," Journal of Monetary Economics, Elsevier, vol. 29(1), pages 3-24, February.
  10. Calvo, Guillermo A., 1983. "Staggered prices in a utility-maximizing framework," Journal of Monetary Economics, Elsevier, vol. 12(3), pages 383-398, September.
  11. Woodford, Michael, 1990. "The optimum quantity of money," Handbook of Monetary Economics, in: B. M. Friedman & F. H. Hahn (ed.), Handbook of Monetary Economics, edition 1, volume 2, chapter 20, pages 1067-1152 Elsevier.
  12. Christiano, Lawrence J & Eichenbaum, Martin & Evans, Charles, 1996. "The Effects of Monetary Policy Shocks: Evidence from the Flow of Funds," The Review of Economics and Statistics, MIT Press, vol. 78(1), pages 16-34, February.
  13. Lawrence J. Christiano & Martin Eichenbaum & Charles L. Evans, 1996. "Sticky price and limited participation models of money: a comparison," Working Paper Series, Macroeconomic Issues WP-96-28, Federal Reserve Bank of Chicago.
  14. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "Monetary policy rules and macroeconomic stability: Evidence and some theory," Economics Working Papers 350, Department of Economics and Business, Universitat Pompeu Fabra, revised May 1999.
  15. Lawrence J. Christiano & Christopher J. Gust, 1999. "Taylor rules in a limited participation model," Working Paper 9902, Federal Reserve Bank of Cleveland.
  16. Julio J. Rotemberg & Michael Woodford, 1998. "Interest-Rate Rules in an Estimated Sticky Price Model," NBER Working Papers 6618, National Bureau of Economic Research, Inc.
  17. William Kerr & Robert G. King, 1996. "Limits on interest rate rules in the IS model," Economic Quarterly, Federal Reserve Bank of Richmond, issue Spr, pages 47-75.
  18. Schlagenhauf, Don E. & Wrase, Jeffrey M., 1995. "Liquidity and real activity in a simple open economy model," Journal of Monetary Economics, Elsevier, vol. 35(3), pages 431-461, June.
  19. Ireland, Peter N., 1997. "A small, structural, quarterly model for monetary policy evaluation," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 47(1), pages 83-108, December.
  20. Taylor, John B., 1993. "Discretion versus policy rules in practice," Carnegie-Rochester Conference Series on Public Policy, Elsevier, vol. 39(1), pages 195-214, December.
  21. Charles T. Carlstrom & Timothy S. Fuerst, 2000. "Forward-looking versus backward-looking Taylor rules," Working Paper 0009, Federal Reserve Bank of Cleveland.
  22. Charles T. Carlstrom & Timothy S. Fuerst, 1995. "Interest rate rules vs. money growth rules: a welfare comparison in a cash-in-advance economy," Working Paper 9504, Federal Reserve Bank of Cleveland.
  23. Charles T. Carlstrom & Timothy S. Fuerst, 2001. "Timing and real indeterminacy in monetary models," Working Paper 9910R, Federal Reserve Bank of Cleveland.
  24. Schmitt-Grohe, Stephanie & Uribe, Martin, 1997. "Balanced-Budget Rules, Distortionary Taxes, and Aggregate Instability," Journal of Political Economy, University of Chicago Press, vol. 105(5), pages 976-1000, October.
  25. Lucas, Robert Jr., 1982. "Interest rates and currency prices in a two-country world," Journal of Monetary Economics, Elsevier, vol. 10(3), pages 335-359.
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