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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 tractable canonical system in domestic inflation and the output gap. We employ this framework to analyze 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 those suboptimal rules.

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Paper provided by Barcelona Graduate School of Economics in its series Working Papers with number 11.

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Date of creation: Dec 2003
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Handle: RePEc:bge:wpaper:11
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