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The Butterfly Effect of Small Open Economies

  • Jarkko Jääskelä

    (Reserve Bank of Australia)

  • Mariano Kulish

    (Reserve Bank of Australia)

The rational expectations equilibrium of a small open economy can be subject to indeterminacy if foreign monetary policy does not satisfy the Taylor principle. We study the implications of foreign-induced indeterminacy for the conduct of monetary policy in a small open economy. In the canonical sticky-price small open economy model, we find that indeterminacy arising in the large economy can increase the volatility of the small economy. Our main finding, however, is that ‘smallness’ is a property of the unique rational expectations equilibrium of the large economy, and not a general property of the small open economy model. If the large economy fails to anchor expectations, shocks to the small economy can affect the large one. This form of indeterminacy gives rise to a ‘butterfly effect’. Additional assumptions are required to preserve the ‘smallness’ of the small economy.

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Paper provided by Reserve Bank of Australia in its series RBA Research Discussion Papers with number rdp2007-06.

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Date of creation: Jun 2007
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Handle: RePEc:rba:rbardp:rdp2007-06
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