Monetary Policy and Exchange Rate Volatility in a Small Open Economy

Jordi Galí and Tommaso Monacelli

The Review of Economic Studies, 2005, vol. 72, issue 3, 707-734

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 simple representation in domestic inflation and the output gap. We use the resulting framework to analyse 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. Copyright 2005, Wiley-Blackwell.

Date: 2005
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Related works:
Working Paper: Monetary Policy and Exchange Rate Volatility in a Small Open Economy (2015)
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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