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Monetary policy and exchange rate volatility in a small open economy

We lay out a small open economy version of the Calvo sticky price model, and show how the equilibrium dynamics can be reduced to simple representation in domestic inflation and the output gap. We use the resulting framework to analyze the macroeconomic implications of three alternative rule-based policy regimes for the small open economy: domestic inflation and CPI-based Taylor rules, and an exchange rate peg. We show that a key difference among these regimes lies in the relative amount of exchange rate volatility that they entail. We also discuss a special case for which domestic inflation targeting constitutes the optimal policy, and where a simple second order approximation to the utility of the representative consumer can be derived and used to evaluate the welfare losses associated with the suboptimal rules.

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File URL: http://www.econ.upf.edu/docs/papers/downloads/835.pdf
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Paper provided by Department of Economics and Business, Universitat Pompeu Fabra in its series Economics Working Papers with number 835.

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Date of creation: Jul 2004
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Handle: RePEc:upf:upfgen:835
Contact details of provider: Web page: http://www.econ.upf.edu/

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  3. Tommaso Monacelli, 1999. "Into the Mussa Puzzle: Monetary Policy Regimes and the Real Exchange Rate in a Small Open Economy," Boston College Working Papers in Economics 437, Boston College Department of Economics, revised 15 Sep 2000.
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