Working Paper: CEPR ID: DP3346
Authors: Jordi Gal; 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 analyse the macroeconomic implications of three alternative monetary policy regimes for the small open economy: domestic inflation targeting, CPI targeting 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 suboptimal regimes.
Keywords: exchange rate peg; exchange rate volatility; optimal monetary policy; small open economy; sticky prices
JEL Codes: E52; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Domestic inflation targeting (E31) | Increased volatility of nominal and real exchange rates (F31) |
| CPI targeting (E31) | Balance between domestic inflation targeting and exchange rate peg (F31) |
| Domestic inflation targeting (E31) | Stabilizes output gap and domestic inflation (E63) |
| CPI targeting (E31) | Mimics domestic inflation targeting in closed economy (E63) |
| CPI targeting (E31) | Behaves like a peg under high openness (F41) |
| Domestic inflation targeting (E31) | Optimal policy minimizing welfare losses (D69) |
| CPI targeting and exchange rate pegs (F31) | Significant deviations from optimal responses to shocks (E32) |
| Excess smoothness in nominal exchange rates (F31) | Welfare losses (D69) |