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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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  1. Svensson, L.E.O., 1998. "Open-Economy Inflation Targeting," Papers 638, Stockholm - International Economic Studies.
  2. Maurice Obstfeld and Kenneth Rogoff., 1995. "Exchange Rate Dynamics Redux," Center for International and Development Economics Research (CIDER) Working Papers C95-048, University of California at Berkeley.
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  4. Benhabib, Jess & Schmitt-Grohe, Stephanie & Uribe, Martin, 2001. "The Perils of Taylor Rules," Journal of Economic Theory, Elsevier, vol. 96(1-2), pages 40-69, January.
  5. M.B. Devereux & Ch. Engel, 2003. "Exchange Rate Pass-Through, Exchange Rate Volatility, and ExchangeRate Disconnect," DNB Staff Reports (discontinued) 77, Netherlands Central Bank.
  6. Stephanie Schmitt-Grohe & Martin Uribe, 2001. "Optimal Fiscal and Monetary Policy Under Sticky Prices," Departmental Working Papers 200105, Rutgers University, Department of Economics.
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  12. Richard Clarida & Jordi Galí & Mark Gertler, 1997. "The science of monetary policy: A new Keynesian perspective," Economics Working Papers 356, Department of Economics and Business, Universitat Pompeu Fabra, revised Apr 1999.
  13. James Bullard & Kaushik Mitra, 2002. "Learning about monetary policy rules," Working Papers 2000-001, Federal Reserve Bank of St. Louis.
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  15. Lane, Philip R., 2001. "The new open economy macroeconomics: a survey," Journal of International Economics, Elsevier, vol. 54(2), pages 235-266, August.
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  26. Laurence Ball, 1998. "Policy Rules for Open Economies," RBA Research Discussion Papers rdp9806, Reserve Bank of Australia.
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  44. Vestin, David, 2000. "Price-level Targeting versus Inflation Targeting in a Forward-looking Model," Working Paper Series 106, Sveriges Riksbank (Central Bank of Sweden).
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