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Monetary Policy and Exchange Rate Volatility in a Small Open Economy

Author

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  • Jordi Galí
  • Tommaso Monacelli
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 tractable canonical system in domestic inflation and the output gap. We employ this framework to analyze 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 those suboptimal rules.

Suggested Citation

  • Jordi Galí & Tommaso Monacelli, 2003. "Monetary Policy and Exchange Rate Volatility in a Small Open Economy," Working Papers 11, Barcelona School of Economics.
    • Handle: RePEc:bge:wpaper:11
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    More about this item

    Keywords

    Small open economy; optimal monetary policy; sticky prices; exchange rate peg; exchange rate volatility;
    All these keywords.

    JEL classification:

    • E52 - Macroeconomics and Monetary Economics - - Monetary Policy, Central Banking, and the Supply of Money and Credit - - - Monetary Policy
    • F41 - International Economics - - Macroeconomic Aspects of International Trade and Finance - - - Open Economy Macroeconomics

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