Monetary policy and exchange rate volatility in a small open economy

Jordi Galí and Tommaso Monacelli

Economics Working Papers from Department of Economics and Business, Universitat Pompeu Fabra

Abstract: 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.

Keywords: Small open economy; optimal monetary policy; sticky prices; exchange rate peg; exchange rate volatility (search for similar items in EconPapers)
JEL-codes: E52 F41 (search for similar items in EconPapers)
Date: 2004-07
New Economics Papers: this item is included in nep-cba, nep-ifn, nep-mac and nep-mon
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Citations: View citations in EconPapers (34)

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Related works:
Working Paper: Monetary Policy and Exchange Rate Volatility in a Small Open Economy (2015)
Journal Article: Monetary Policy and Exchange Rate Volatility in a Small Open Economy (2005)
Working Paper: Monetary Policy and Exchange Rate Volatility in a Small Open Economy (2002)
Working Paper: Monetary Policy and Exchange Rate Volatility in a Small Open Economy (2002)
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Persistent link: https://EconPapers.repec.org/RePEc:upf:upfgen:835

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