Optimal Monetary Policy and Exchange Rate Volatility in a Small Open Economy

Jordi Galí and Tommaso Monacelli

No 438, Boston College Working Papers in Economics from Boston College Department of Economics

Abstract: We lay out a tractable small open economy version of the canonical sticky price model, and use it as a framework to study the properties of three alternative monetary regimes: (a) optimal monetary policy, (b) a Taylor rule, and (c) an exchange rate peg. Several interesting results emerge from our analysis. First, the optimal policy is shown to entail a positive correlation between domestic and world interest rates. That doesn't prevent sizable fluctuations of nominal and real exchange rates from occurring, though the implied volatility of those variables is much smaller than the empirical one. Second, a Taylor rule generally leads to excess volatility of nominal variables, and excess smoothness of real variables, relative to the optimal policy. Finally, we show that a pure exchange rate peg causes the equilibrium to be indeterminate and may thus be a source of macroeconomic instability.

Keywords: small open economy; optimal monetary policy; sticky prices; Taylor rule (search for similar items in EconPapers)
JEL-codes: E52 F41 (search for similar items in EconPapers)
Date: 1999-01-15, Revised 1999-11-15
New Economics Papers: this item is included in nep-dge, nep-ifn and nep-mon
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (108)

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Persistent link: https://EconPapers.repec.org/RePEc:boc:bocoec:438

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