Working Paper: CEPR ID: DP5522
Authors: Ester Faia; Tommaso Monacelli
Abstract: We analyze optimal monetary policy in a small open economy characterized by home bias in consumption. Peculiar to our framework is the application of a Ramsey-type analysis to a model of the recent open economy New Keynesian literature. We show that home bias in consumption is a sufficient condition for inducing monetary policy-makers of an open economy to deviate from a strategy of strict markup stabilization and contemplate some (optimal) degree of exchange rate stabilization. We focus on the optimal setting of policy both in the case in which firms set prices one period in advance as well as in the case in which firms set prices in a dynamic forward-looking fashion. While the first setup allows us to analytically highlight home bias as an independent source of equilibrium markup variability, the second setup allows us to study the effects of future expectations on the optimal policy problem and the effect of home bias on optimal inflation volatility. The latter, in particular, is shown to be related to the degree of trade openness in a U-shaped fashion, whereas exchange rate volatility is monotonically decreasing in openness.
Keywords: home bias; optimal monetary policy; Ramsey planner; 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 |
|---|---|
| Home bias in consumption (D12) | Optimal monetary policy (E63) |
| Home bias in consumption (D12) | Exchange rate stabilization (F31) |
| Trade openness (F43) | Optimal inflation volatility (E31) |
| Future expectations (D84) | Optimal policy effectiveness (D78) |