Optimal devaluations

Constantino Hevia and Juan Pablo Nicolini

No 702, Working Papers from Federal Reserve Bank of Minneapolis

Abstract: 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 interna-tionally 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 not only is in line with the long-standing tradition of small open economy models, but also changes the optimal movements in the exchange rate. In contrast with the recent small open economy New Keynesian literature, our model is able to reproduce the comovement between the nominal exchange rate and the price of exports, as it has been documented in the commodity currencies literature. Although we show there are preferences for which price stability is optimal even without flexible fiscal instruments, our model suggests that more attention should be given to the coordination between monetary and fiscal policy (taxes) in small open economies that are heavily dependent on exports of commodities. The model we propose is a useful framework in which to study fear of floating.

Keywords: Monetary; policy (search for similar items in EconPapers)
Date: 2013
New Economics Papers: this item is included in nep-mac, nep-mon and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (9)

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Related works:
Journal Article: Optimal Devaluations (2013)
Working Paper: Optimal Devaluations (2011)
Working Paper: Optimal devaluations (2009)
Working Paper: Optimal Devaluations (2004)
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Persistent link: https://EconPapers.repec.org/RePEc:fip:fedmwp:702

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