Optimal Devaluations

We analyze optimal policy in a simple small open economy model with price setting frictions. In particular, we study the optimal response of the nominal exchange rate following a terms of trade shock. We depart from the New Keynesian literature in that we explicitly model internationally traded commodities as intermediate inputs in the production of local final goods and assume that the small open economy takes this price as given. This modification is not only in line with the long standing tradition of small open economy models, but also drastically changes the optimal movements in the exchange rate. We perform our analysis in the tradition of optimal dynamic Ramsey problems, so we characterize optimal allocation and the government policies that implement it. We show that, while we can derive general second best policy principles, the exact way the nominal exchange rate ought to comove with the terms of trade depends on specific details of the model.