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Price Stability In Small Open Economies

Mikhail Dmitriev and Jonathan Hoddenbagh ()

MPRA Paper from University Library of Munich, Germany

Abstract: We study the conduct of monetary policy in a continuum of small open economies. We solve the model globally in closed form without restricting the elasticity of substitution between home and foreign goods to one. Using this global closed-form solution, we give an exact characterization of optimal monetary policy and welfare with and without international policy cooperation. We consider the cases of internationally complete asset markets and financial autarky, producer currency pricing and local currency pricing. Under producer currency pricing, it is always optimal to mimic the flexible-price equilibrium through a policy of price stability. Under local currency pricing, policy should fix the exchange rate. Even if substitutability differs from one, the continuum of small open economies implies that the share of each country's output in the world consumption basket (and therefore the impact of the country's monopoly power) is negligible. This removes the incentive to deviate from price stability under producer currency pricing or a fixed exchange rate under local currency pricing. There are no gains from international monetary cooperation in all cases examined. Our results stand in contrast to those in the literature on optimal monetary policy for large open economies, where strategic interactions drive optimal policy away from price stability or fixed exchange rates, and gains from cooperation are present, when substitutability differs from one.

Keywords: Open economy macroeconomics; Optimal monetary policy; Price stability. (search for similar items in EconPapers)
JEL-codes: E50 F41 F42 (search for similar items in EconPapers)
Date: 2012-11, Revised 2013-02
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Working Paper: Price Stability In Small Open Economies (2013) Downloads
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