Openness and Optimal Monetary Policy

Giovanni Lombardo and Federico Ravenna

Cahiers de recherche from CIRPEE

Abstract: We show that the composition of international trade has important implications for the optimal volatility of the exchange rate, above and beyond the size of trade flows. Using an analytically tractable small open economy model, we characterize the impact of the trade composition on the policy trade-off and on the role played by the exchange rate in correcting for price misalignments. Contrary to models where openness can be summarized by the degree of home bias, we find that openness can be a poor proxy of the welfare impact of alternative monetary policies. Using input-output data for 25 countries we document substantial differences in the import and non-tradable content of final demand components, and in the role played by imported inputs in domestic production. The estimates are used in a richer small-open-economy DSGE model to quantify the loss from an exchange rate peg relative to the Ramsey policy conditional on the composition of imports. We find that the main determinant of the losses is the share of non-traded goods in final demand.

Keywords: International Trade; Exchange Rate Regimes; Non-tradable Goods; Optimal Policy (search for similar items in EconPapers)
JEL-codes: E3 E42 E52 F41 (search for similar items in EconPapers)
Date: 2014
New Economics Papers: this item is included in nep-dge, nep-int, nep-mac, nep-mon and nep-opm
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (38)

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Related works:
Journal Article: Openness and optimal monetary policy (2014)
Working Paper: Openness and optimal monetary policy (2010)
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Persistent link: https://EconPapers.repec.org/RePEc:lvl:lacicr:1410

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