Working Paper: NBER ID: w18536
Authors: Luis Catao; Roberto Chang
Abstract: We develop a dynamic model of a small open economy that trades commodities whose world prices are subject to realistic random fluctuations, and study the implications of monetary policy alternatives. The model is much more flexible than those of previous studies, especially in allowing to compare perfect risk sharing against financial autarky. In each case we show how to derive analytically optimal Ramsey allocations and flexible price allocations, and hence to examine the crucial role of behavioral elasticities, production structure, and capital mobility in determining the welfare properties of different monetary choices. Applying these insights to a calibrated example, we find that the impulse responses associated with PPI targeting track flexible price allocations closely, but can diverge greatly from the Ramsey allocations, especially when risk sharing is perfect and the elasticity of demand for exports of a home aggregate is high. In those cases, policies that stabilize the real exchange rate more than PPI targeting, such as targeting expected inflation, deliver higher welfare. But PPI targeting is the clear winner under portfolio autarky.
Keywords: monetary policy; commodity prices; PPI targeting; CPI targeting; small open economies
JEL Codes: E52; F41
Edges that are evidenced by causal inference methods are in orange, and the rest are in light blue.
| Cause | Effect |
|---|---|
| Perfect risk sharing (D81) | PPI targeting is welfare superior to other rules (D69) |
| Elasticities of substitution not too different from one (D11) | PPI targeting is welfare superior to other rules (D69) |
| Large elasticities (H30) | Expected CPI targeting or EPI targeting may dominate PPI targeting (E31) |
| Structure of production and degree of international risk sharing (F61) | Relative desirability of different monetary rules (E49) |
| Portfolio autarky (F00) | PPI targeting emerges as a clear winner (L19) |
| Terms of trade externality (F14) | Effectiveness of monetary policy (E52) |