Optimal monetary policy in a small open economy with staggered wage and price contracts

We study optimal monetary policy for a small open economy in a model where both domestic prices and wages are sticky due to staggered contracts. The simultaneous presence of the two forms of nominal rigidities introduces an additional trade-off between domestic inflation and the output gap. We derive a second-order approximation to the average welfare losses that can be expressed in terms of the unconditional variances of the output gap, domestic price inflation, and wage inflation. As a consequence, the optimal policy seeks to minimize a weighted average of these variances. We analyze welfare implications of several alternative simple policy rules, and find that domestic price inflation targeting generates relatively large welfare losses, whereas CPI inflation targeting performs nearly as well as the optimal rule.     

Optimal fiscal and monetary policy in an economy without capital

This paper is concerned with the structure and time-consistency of optimal fiscal and monetary policy in an economy without capital. In a dynamic context, optimal taxation means distributing tax distortions over time in a welfare-maximizing way. For a barter economy, our main finding is that with debt commitments of sufficiently rich maturity structure, an optimal policy, if one exists, is time-consistent. In a monetary economy, the idea of optimal taxation must be broadened to include an ‘inflation tax’, and we find that time-consistency does not carry over. An optimal ‘inflation tax’ requires commitment by ‘rules’ in a sense that has no counterpart in the dynamic theory of ordinary excise taxes. The reason time-consistency fails in a monetary economy is that nominal assets should, from a welfare-maximizing point of view, always be taxed away via an immediate inflation in a kind of ‘capital levy’. This emerges as a new possibility when money is introduced into an economy without capital.     

Inventories and optimal monetary policy in a small open economy

We study how inventory investment affects the design of optimal monetary policy in a New Keynesian small open economy model. We find that under producer currency pricing, when the intratemporal elasticity of substitution is smaller than 1, optimal monetary policy in our model with inventories is similar to a standard model without inventories. However, when the intratemporal elasticity of substitution is larger than 1, inventory investment increases the importance of nominal exchange rate stabilization relative to a standard model without inventories. The importance of nominal exchange rate stabilization increases with the intratemporal elasticity of substitution.     

Capital controls and monetary policy autonomy in a small open economy

Is there a link between capital controls and monetary policy autonomy in a country with a floating currency? Shocks to capital flows into a small open economy lead to volatility in asset prices and credit supply. To lessen the impact of capital flows on financial instability, a central bank finds it optimal to use the domestic interest rate to “manage” the capital account. Capital account restrictions affect the behavior of optimal monetary policy following shocks to the foreign interest rate. Capital controls allow optimal monetary policy to focus less on the foreign interest rate and more on domestic variables.     

Optimal fiscal and monetary policy with sticky prices

In this paper I consider the role of state-contingent inflation as a fiscal shock absorber in an economy with nominal rigidities. I study the Ramsey equilibrium in a monetary model with distortionary taxation, nominal non-state-contingent debt, and sticky prices. With sticky prices, the Ramsey planner must balance the shock absorbing benefits of state-contingent inflation against the associated resource misallocation costs. For government spending processes resembling post-war experience, introducing sticky prices generates striking departures in optimal policy from the case with flexible prices. For even small degrees of price rigidity, optimal policy displays very little volatility in inflation. Tax rates display greater volatility compared to the model with flexible prices. With sticky prices, tax rates and real government debt exhibit behavior similar to a random walk. For government spending processes resembling periods of intermittent war and peace, optimal policy displays extreme inflation volatility even when the degree of price rigidity is large. As the variability in government spending increases, smoothing tax distortions across states of nature becomes increasingly important, and the shock absorber role of inflation is accentuated.     

Identifying monetary policy in a small open economy under flexible exchange rates

Previous empirical study on the effects of monetary policy shocks in small open economies has generated puzzling dynamic responses in various macroeconomic variables. This paper argues that these puzzles derive from an identification of monetary policy that is inappropriate for such economies. To remedy this, it is proposed that a structural model be estimated to explicitly account for the features of the small open economy. Such a model is applied to Canada with tightly estimated results overall. The dynamic responses to the identified monetary policy shock are consistent with standard theory and highlight the exchange rate as a transmission mechanism.     

Optimal foreign exchange-rate policy for a small open economy

This paper examines optimal exchange-rate policy for a small open economy which faces temporary and pemanent, real and nominal disturbances. It demonstrates that exchange-rate stabilization is desirable if most diturbances are nominal. If most disturbances are real, then stabilization should be greater: (1) the greater the fraction of exchange-rate variance accounted for by permanent disturbances; (2) the greater the information available to firms in setting the wage; (3) the greater the fraction of exchange-rate variance attributed to domestic productivity shocks compared with foreign relative price shocks; and (4) the more elastic is labor supply.     

Optimal monetary policy in an economy with inflation persistence

This paper studies optimal monetary policy in a model where inflation is persistent. Two types of price setters are assumed to exist. One acts rationally given Calvo-type constraints on price setting. The other type sets prices according to a rule-of-thumb. This results in a Phillips curve with both a forward-looking term and a backward-looking term. The Phillips curve nests a standard purely forward-looking Phillips curve as well as a standard purely backward-looking Phillips curve as special cases. A cost push supply shock is derived from microfoundations by adding a time varying income tax and by making the elasticity of substitution between goods stochastic. A central bank loss function for this model is derived from a second-order Taylor approximation of the household's welfare function. Optimal monetary policy for different relative values of the forward- and backward-looking terms is then analyzed for both the commitment case and the case of discretion.     

India's fiscal and monetary framework: growth in an opening economy

Since a crisis is a shock impinging on a system, the response can be used to deduce aspects of the system's structure. Analysis of the crisis and recovery suggests aggregate supply in India is elastic but subject to upward shocks. This has implications for cyclical policy and for fiscal consolidation. Both monetary and fiscal policy should identify measures that would reduce costs, while avoiding too large a demand contraction. Specific policies are identified and Indian policies evaluated.     

Macroprudential policy transmission and interaction with fiscal and monetary policy in an emerging economy: a DSGE model for Brazil

We investigate the transmission of macroprudential (MaP) instruments in a dynamic stochastic general equilibrium model where foreign capital flows interact with financial frictions and banks are exposed to different sources of credit default risk. The model is estimated for Brazil with Bayesian techniques. We compute optimal combinations of simple MaP, fiscal and monetary policy rules that can react to the business and/or the financial cycle. We find that the gains from implementing a cyclical fiscal policy are only significant if MaP policy countercyclically reacts to the financial cycle. Optimal fiscal policy is countercyclical in the business cycle.     

Optimal monetary policy in an economy with incomplete markets and idiosyncratic risk

This study investigates an incomplete markets economy in which the saving behavior of a continuum of infinitely lived agents is influenced by precautionary saving motives and borrowing constraints. Agents can use two types of assets (interest bearing IOUS and money) to smooth consumption. Money is valued because of a timing friction in the bond market. In particular, the bond market closes before agents observe their idiosyncratic productivity shock. I find that the Friedman rule is not optimal for this economy. The results indicate that the optimal allocation has a rate of inflation of 10%, and a positive amount of private credit held by the government. A positive inflation rate transfers resources from agents with big endowments to those holding bonds which improves risk sharing, and therefore, welfare. However, for higher rates of inflation, agents economize on money holdings, offsetting the insurance effects, and causing a reduction in welfare. Furthermore, higher rates of inflation discourage agents from borrowing, and the endogenous lower bound on bond holdings is higher than the exogenous borrowing limit. High rates of inflation, therefore, exacerbate frictions in the bond market.     

Optimal exchange intervention for a small open economy

This paper investigates the optimal exchange intervension strategy for a small open economy in which both the domestic price level and domestic real GNP are endogenous, with the authority's objective being to stabilize a function involving both these variables. A special feature of the underlying macro model is that real balances are productive. Ultimately, this will mean that aggregate supply is sensitive to nominal interest rates. Additionally, both expectations and the intervention policy are designed to exploit the fact that financial market data, such as exchange and interest rates, are observable on a fairly current basis. Contrary to conventional wisdom, optimal intervention will usually require accentuating, not moderating, current exchange rate movements.     

Optimal wage indexation and monetary policy in an economy with imported raw materials

An economy's openness from the input side has important effects on the optimal design of its macroeconomic policies. Given the exchange rate regime, the larger the share of imported raw materials in domestic production, the smaller the optimal degree of wage indexation to unanticipated inflation. Alternatively, given the wage indexation parameter, the larger the share of imported raw materials in domestic production, the smaller the optimal degree of foreign exchange intervention by the monetary authority (the more flexible the exchange rate).     

Principles of fiscal and monetary policy

This paper describes a complete and internally consistent set of principles for the conduct of a welfare-maximizing fiscal and monetary policy. Issues of time-consistency that arise in applying these principles to actual economics are also discussed.     

International monetary policy transmission through banks in small open economies

This paper studies the international transmission of monetary policy through banks in small open economies using the examples of Switzerland and Canada. We assess the inward transmission of foreign monetary policy for Switzerland and the outward transmission of domestic monetary policy for Canada. In both country cases, we focus on the international bank lending and the international portfolio channel, which make opposing predictions about how monetary policy transmits internationally through banks. Our results on the inward transmission of foreign monetary policy through banks in Switzerland are consistent with a role for the international portfolio channel, but we find no evidence for the traditional international bank lending channel. The results on the outward transmission of domestic monetary policy in Canada suggest that foreign lending by Canadian banks is affected through both channels, which work as predicted and largely balance each other.     

Optimal factor and commodity taxation in a small open economy

A two-sector trade model with specific factors and perfect international capital mobility is used to analyze the optimal mix of factor and commodity taxation in a small open economy that faces domestic or international constraints on its tax instruments. In the unconstrained benchmark case, the small country will tax specific factors and domestic consumption but chooses zero tax rates for a selective production tax (i.e., an origin-based commodity tax) and a source-based tax on capital income. When commodity taxation must follow a combination of origin and destination principles, then this mixed commodity tax rate will be positive and its production effects are partly compensated in the optimum by a capital subsidy. These international restrictions interact with domestic constraints when rents accruing to fixed factors cannot be taxed by a separate instrument, and a positive tax rate on capital serves as an indirect way of rent taxation.     

The open economy consequences of U.S. monetary policy

We consider the open economy consequences of U.S. monetary policy, extending the identification approach of Romer and Romer (2004) and adapting it for use with asset prices. Intended policy changes are orthogonalized against the economy’s expected future path, which captures any effects from open economy variables. Estimated from a set of bilateral VARs, the dynamic responses of the exchange rate, foreign interest rate, and foreign output are consistent with recent work that identifies U.S. policy via futures market changes and a priori impulse response bounds. We compare the two approaches, finding important commonalities. We also outline some advantages of our approach.