Optimal Monetary Policy in a Small Open Economy with Home Bias

Tommaso Monacelli and Ester Faia

No 5522, CEPR Discussion Papers from C.E.P.R. Discussion Papers

Abstract: We analyze optimal monetary policy in a small open economy characterized by home bias in consumption. Peculiar to our framework is the application of a Ramsey-type analysis to a model of the recent open economy New Keynesian literature. We show that home bias in consumption is a sufficient condition for inducing monetary policy-makers of an open economy to deviate from a strategy of strict markup stabilization and contemplate some (optimal) degree of exchange rate stabilization. We focus on the optimal setting of policy both in the case in which firms set prices one period in advance as well as in the case in which firms set prices in a dynamic forward-looking fashion. While the first setup allows us to analytically highlight home bias as an independent source of equilibrium markup variability, the second setup allows us to study the effects of future expectations on the optimal policy problem and the effect of home bias on optimal inflation volatility. The latter, in particular, is shown to be related to the degree of trade openness in a U-shaped fashion, whereas exchange rate volatility is monotonically decreasing in openness.

Keywords: Optimal monetary policy; Ramsey planner; Home bias; Sticky prices (search for similar items in EconPapers)
JEL-codes: E52 F41 (search for similar items in EconPapers)
Date: 2006-03
New Economics Papers: this item is included in nep-cba, nep-fmk, nep-ifn, nep-mac and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (8)

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Related works:
Journal Article: Optimal Monetary Policy in a Small Open Economy with Home Bias (2008)
Journal Article: Optimal Monetary Policy in a Small Open Economy with Home Bias (2008)
Working Paper: Optimal Monetary Policy in a Small Open Economy with Home Bias (2006)
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