Monetary Policy and Exchange Rate Volatility in a Small Open Economy |
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Authors: | Jordi Galí Tommaso Monacelli |
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Institution: | ;CREI, UPF, CEPR and NBER ;IGIER, UniversitàBocconi and CEPR |
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Abstract: | We lay out a small open economy version of the Calvo sticky price model, and show how the equilibrium dynamics can be reduced to a simple representation in domestic inflation and the output gap. We use the resulting framework to analyse the macroeconomic implications of three alternative rule-based policy regimes for the small open economy: domestic inflation and CPI-based Taylor rules, and an exchange rate peg. We show that a key difference among these regimes lies in the relative amount of exchange rate volatility that they entail. We also discuss a special case for which domestic inflation targeting constitutes the optimal policy, and where a simple second order approximation to the utility of the representative consumer can be derived and used to evaluate the welfare losses associated with the suboptimal rules. |
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