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Price Stability In Small Open Economies

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  • Dmitriev, Mikhail
  • Hoddenbagh, Jonathan

Abstract

We study the conduct of monetary policy in a continuum of small open economies. We solve the model globally in closed form without restricting the elasticity of substitution between home and foreign goods to one. Using this global closed-form solution, we give an exact characterization of optimal monetary policy and welfare with and without international policy cooperation. We consider the cases of internationally complete asset markets and financial autarky, producer currency pricing and local currency pricing. Under producer currency pricing, it is always optimal to mimic the flexible-price equilibrium through a policy of price stability. Under local currency pricing, policy should fix the exchange rate. Even if substitutability differs from one, the continuum of small open economies implies that the share of each country's output in the world consumption basket (and therefore the impact of the country's monopoly power) is negligible. This removes the incentive to deviate from price stability under producer currency pricing or a fixed exchange rate under local currency pricing. There are no gains from international monetary cooperation in all cases examined. Our results stand in contrast to those in the literature on optimal monetary policy for large open economies, where strategic interactions drive optimal policy away from price stability or fixed exchange rates, and gains from cooperation are present, when substitutability differs from one.

Suggested Citation

  • Dmitriev, Mikhail & Hoddenbagh, Jonathan, 2012. "Price Stability In Small Open Economies," MPRA Paper 46132, University Library of Munich, Germany, revised Feb 2013.
  • Handle: RePEc:pra:mprapa:46132
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    References listed on IDEAS

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    Cited by:

    1. Dmitriev, Mikhail & Hoddenbagh, Jonathan, 2012. "The optimal design of a fiscal union," MPRA Paper 46007, University Library of Munich, Germany, revised Apr 2013.
    2. Matteo Cacciatore, 2013. "Trade, Unemployment, and Monetary Policy," 2013 Meeting Papers 724, Society for Economic Dynamics.

    More about this item

    Keywords

    Open economy macroeconomics; Optimal monetary policy; Price stability.;

    JEL classification:

    • E50 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - General
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics
    • F42 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - International Policy Coordination and Transmission

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