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Trade Openness and Monetary Policy Rules

Guillermo Calvo

No 1030, 2007 Meeting Papers from Society for Economic Dynamics

Abstract: The paper examines the link between trade openness and the benefits of exchange rate flexibility under real foreign shocks and nominal rigidities. The benefits of exchange rate flexibility are defined as the welfare difference between outcomes under fixed exchange rates and under an optimized interest rate rule. We use a carefully calibrated five-sector model of the Chilean economy with multiple foreign trade links as our baseline, and then create more or less open economies by varying technology and preference parameters. For each economy we determine an optimized monetary policy rule by maximizing welfare based on a third order approximation of the model. Preliminary results suggest that there is no strong monotonic relationship between trade openness and the degree of exchange rate flexibility. The sensitivity of our results to critical assumptions such a producer currency pricing will be explored.

Date: 2007
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