Working Paper: CEPR ID: DP1231
Authors: Neil Rankin
Abstract: A dynamic stochastic model of a small open monetary economy with infinitely-lived optimizing households is constructed. There are temporary nominal rigidities in the labour market, while in goods and asset markets prices are flexible. Optimizing behaviour in the foreign country is also modelled. The home country is small relative to the foreign country, so the latter is effectively a closed economy. We show that whereas in the closed economy an anticipated increase in monetary variability has no effect on current macroeconomic variables, in the small open economy it weakens the current exchange rate and expands current output.
Keywords: monetary uncertainty; nominal rigidity; exchange rate; risk premium
JEL Codes: E44; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| anticipated increase in monetary variability (E39) | reduction in domestic households' wealth (E21) |
| reduction in domestic households' wealth (E21) | depreciation of the domestic currency (F31) |
| depreciation of the domestic currency (F31) | expansion of current output (E23) |
| anticipated increase in monetary variability (E39) | depreciation of the domestic currency (F31) |
| anticipated increase in monetary variability (E39) | expansion of current output (E23) |
| reduction in domestic households' wealth (E21) | decrease in demand for domestic currency (F31) |
| depreciation of the domestic currency (F31) | enhanced competitiveness of domestic firms (F23) |
| enhanced competitiveness of domestic firms (F23) | increased output and employment (E23) |
| domestic monetary uncertainty (E49) | no effect on foreign exchange risk premium (F31) |