Is more exchange rate intervention necessary in small open economies? The role of risk premium and commodity shocks

Carlos García and Wildo Gonzalez P. ()

ILADES-UAH Working Papers from Universidad Alberto Hurtado/School of Economics and Business

Abstract: We estimate how the monetary policy works in small open economies with inflation target. To do so, we build a dynamic stochastic general equilibrium model that incorporates the basic features of these economies. We conclude that the monetary policy in a group of representative small open economies (including Australia, Chile, Colombia, Peru and New Zealand) presents strong differences due to shocks from the international financial markets (risk premium shocks, mainly) that explain mostly the variability of the real exchange rate, which has important reallocation effects in the short run. By using the allocations of the Ramsey problem as benchmark, this article shows that if the central banks in small open economies want to reduce the observed volatility of the inflation rate and the output gap, more exchange rate intervention is necessary in order to reduce the volatility produced by risk premium shocks.

Keywords: Small open economies economy models; monetary policy rules; exchange rates; Bayesian econometrics, Risk premium shocks, Ramsey problem. (search for similar items in EconPapers)
JEL-codes: C32 E52 F41 (search for similar items in EconPapers)
Pages: 25 pages
Date: 2010-04
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac, nep-mon and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (2)

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