ANATOMIZING INCOMPLETE-MARKETS SMALL OPEN ECONOMIES: POLICY TRADE-OFFS AND EQUILIBRIUM DETERMINACY
Jaime Alonso-Carrera () and
Timothy Kam
Macroeconomic Dynamics, 2016, vol. 20, issue 4, 1022-1050
Abstract:
We propose a simple incomplete-markets small-open-economy model that is amenable to analytical dissection of its policy-relevant mechanisms. In contrast to its complete-markets limit, the equilibrium real exchange rate is irreducible from the incomplete-markets equilibrium. Market incompleteness exacerbates the domestic-inflation and output-gap monetary-policy trade-off in two ways: its steepness and its resulting endogenous cost-push to the trade-off. The latter depends on an equilibrium combination of structural shocks and on agents' beliefs of future events. Thus, in comparison to its complete-markets and closed-economy limits, standard Taylor-type rules are less capable of inducing determinate rational expectations equilibrium in our environment. Despite the larger policy trade-off under incomplete markets, simple policies that also respond to exchange-rate growth are able to manage expectations that drive the endogenous cost-push term. However, policies that respond directly to expectations may turn out to exacerbate the cost-push trade-off further, and thus, to be more likely to fuel self-fulfilling multiple or unstable equilibria.
Date: 2016
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Persistent link: https://EconPapers.repec.org/RePEc:cup:macdyn:v:20:y:2016:i:04:p:1022-1050_00
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