Monetary Policy in a Small Open Economy with Multiple Monetary Assets

This paper revisits the issue of money measurement in the context of a New Keynesian framework with sticky prices and monopolistic competition, where money matters. We adopt the framework for a small open economy with home bias in consumption from Faia and Monacelli (2008) and follow Belongia and Ireland (2014) in their closed economy New Keynesian model by adding commercial banks in the financial sector. We construct various measures of money supply, including the traditional simple-sum and the Divisia index, originated by Barnett (1980). Through simulation of equilibrium dynamics with various shocks and variation of parameters, we find that the Divisia index tracks the movement of money most closely to the aggregation theoretic benchmark, followed by the monetary base, while simple sum often fails to match the correct trend. In a classical model with perfect competition and perfect markets with no rigidities, the tracking advantage of Divisia is derivable, as in Barnett (1980). But in the New Keynesian model, the aggregation theoretic proof is compromised and best investigated empirically. We further analyze the impact of openness on the volatility of macroeconomic variables. We find that as the small economy becomes more open, domestic inflation and nominal interest rates are more volatile, while terms of trade and exchange rates become more stable. In this regard, the Divisia index and the monetary base, without payment of interest on reserves, follow the correct trend, while the simple-sum, again, does not.