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Why Does Monetary Policy Respond to the Real Exchange Rate in Small Open Economies? A Bayesian Perspective

Carlos García

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

Abstract: To estimate how monetary policy works in small open economies, 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 small open economies (including Australia, Chile, Colombia, Peru, and New Zealand) is rather similar to that observed in closed economies. Our results also indicate, however, that there are strong differences due to shocks from the international financial markets (mainly risk premium shocks). These differences explain most of the variability of the real exchange rate, which has important reallocation effects in the short run. Our results are consistent with an old idea from the Mundell-Fleming model: namely, a real depreciation to confront a risk premium shock is expansive or procyclical, in contradiction to the predictions of the balance sheet effect, the J curve effect, and the introduction of working capital into RBC models. In line with this last result, we have strong evidence that only in one of the five countries analyzed in this study does not intervene the real exchange rate, the case of New Zealand.

Keywords: small open economy models; monetary policy rules; exchange rates; Bayesian econometrics (search for similar items in EconPapers)
JEL-codes: E52 F33 F41 (search for similar items in EconPapers)
Pages: 64 pages
Date: 2012-11
New Economics Papers: this item is included in nep-cba, nep-dge, nep-mac, nep-mon and nep-opm
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Journal Article: Why does monetary policy respond to the real exchange rate in small open economies? A Bayesian perspective (2014) Downloads
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