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Openness and Optimal Monetary Policy

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  • Giovanni Lombardo
  • Federico Ravenna

Abstract

We show that the composition of international trade has important implications for the optimal volatility of the exchange rate, above and beyond the size of trade flows. Using an analytically tractable small open economy model, we characterize the impact of the trade composition on the policy trade-off and on the role played by the exchange rate in correcting for price misalignments. Contrary to models where openness can be summarized by the degree of home bias, we find that openness can be a poor proxy of the welfare impact of alternative monetary policies. Using input-output data for 25 countries we document substantial differences in the import and non-tradable content of final demand components, and in the role played by imported inputs in domestic production. The estimates are used in a richer small-open-economy DSGE model to quantify the loss from an exchange rate peg relative to the Ramsey policy conditional on the composition of imports. We find that the main determinant of the losses is the share of non-traded goods in final demand.

Suggested Citation

  • Giovanni Lombardo & Federico Ravenna, 2014. "Openness and Optimal Monetary Policy," Cahiers de recherche 1410, CIRPEE.
  • Handle: RePEc:lvl:lacicr:1410
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    2. Lombardo, Giovanni & Ravenna, Federico, 2012. "The size of the tradable and non-tradable sectors: Evidence from input–output tables for 25 countries," Economics Letters, Elsevier, vol. 116(3), pages 558-561.
    3. Povoledo, Laura, 2018. "Pricing behavior and the role of trade openness in the transmission of monetary shocks," Journal of Macroeconomics, Elsevier, vol. 57(C), pages 231-247.
    4. Kaufmann, Christoph, 2019. "Optimal fiscal substitutes for the exchange rate in monetary unions," Journal of Economic Dynamics and Control, Elsevier, vol. 103(C), pages 43-62.
    5. Banerjee, Ryan & Devereux, Michael B. & Lombardo, Giovanni, 2016. "Self-oriented monetary policy, global financial markets and excess volatility of international capital flows," Journal of International Money and Finance, Elsevier, vol. 68(C), pages 275-297.
    6. Raphael Auer & Claudio Borio & Andrew Filardo, 2017. "The globalisation of inflation: the growing importance of global value chains," BIS Working Papers 602, Bank for International Settlements.
    7. Brian Micallef, 2013. "Measuring the effects of structural reforms in Malta: an analysis using the EAGLE model," CBM Working Papers WP/01/2013, Central Bank of Malta.
    8. Klein, Mathias & Linnemann, Ludger, 2021. "Real exchange rate and international spillover effects of US technology shocks," Journal of International Economics, Elsevier, vol. 129(C).
    9. Dieudonné Mignamissi, 2018. "Monnaie unique et intégration par le marché en Afrique: le cas de la CEEAC et de la CEDEAO," African Development Review, African Development Bank, vol. 30(1), pages 71-85, March.
    10. Caterina Mendicino, 2014. "House prices and expectations," Research Bulletin, European Central Bank, vol. 21, pages 12-15.
    11. Xia, Tian, 2020. "The role of intermediate goods in international monetary cooperation," Journal of International Money and Finance, Elsevier, vol. 100(C).
    12. Wen Zhang, 2020. "Can trade openness affect the monetary transmission mechanism?," Review of International Economics, Wiley Blackwell, vol. 28(2), pages 341-364, May.
    13. Chen, Ping-ho & Lai, Ching-chong & Chu, Hsun, 2016. "Welfare effects of tourism-driven Dutch disease: The roles of international borrowings and factor intensity," International Review of Economics & Finance, Elsevier, vol. 44(C), pages 381-394.
    14. William D. Craighead, 2020. "Intermediate Goods and Exchange Rate Disconnect," Open Economies Review, Springer, vol. 31(1), pages 113-129, February.
    15. Drechsel, Thomas & McLeay, Michael & Tenreyro, Silvana, 2019. "Monetary policy for commodity booms and busts," CEPR Discussion Papers 14030, C.E.P.R. Discussion Papers.
    16. Paloma Lopez-Garcia & Filippo di Mauro, 2014. "Assessing competitiveness: initial results from the new compnet micro-based database," Research Bulletin, European Central Bank, vol. 21, pages 2-7.
    17. Philip R Lane & Livio Stracca, 2018. "Can appreciation be expansionary? Evidence from the euro area," Economic Policy, CEPR;CES;MSH, vol. 33(94), pages 225-264.
    18. Craighead, William, 2017. "Intermediate Goods and Exchange Rate Disconnect," MPRA Paper 83075, University Library of Munich, Germany.
    19. Sebastian Schmidt, 2014. "Dealing with a liquidity trap when government debt matters," Research Bulletin, European Central Bank, vol. 21, pages 8-11.

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    More about this item

    Keywords

    International Trade; Exchange Rate Regimes; Non-tradable Goods; Optimal Policy;
    All these keywords.

    JEL classification:

    • E3 - Macroeconomics and Monetary Economics - - Prices, Business Fluctuations, and Cycles
    • E42 - Macroeconomics and Monetary Economics - - Money and Interest Rates - - - Monetary Sytsems; Standards; Regimes; Government and the Monetary System
    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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