Monetary Policy and Exchange Rate Volatility in a Small Open Economy

Jordi Gali () and Tommaso Monacelli

No 3346, CEPR Discussion Papers from C.E.P.R. Discussion Papers

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 a tractable canonical system in domestic inflation and the output gap. We employ this framework to analyse the macroeconomic implications of three alternative monetary policy regimes for the small open economy: domestic inflation targeting, CPI targeting 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 suboptimal regimes.

Keywords: exchange rate peg; exchange rate volatility; optimal monetary policy; small open economy; sticky prices (search for similar items in EconPapers)
JEL-codes: E52 F41 (search for similar items in EconPapers)
New Economics Papers: this item is included in nep-cba, nep-dge, nep-ifn, nep-mac and nep-mon
Date: 2002-04
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Related works:
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 (2004)
Journal Article: Monetary Policy and Exchange Rate Volatility in a Small Open Economy (2005)
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