Working Paper: NBER ID: w8721
Authors: Eric Parrado; Andrs Velasco
Abstract: Using an optimizing model we derive the optimal monetary and exchange rate policy for a small stochastic open economy with imperfect competition and short run price rigidity. The optimal monetary policy has an exact closed-form solution and is obtained using the utility function of the representative home agent as welfare criterion. The optimal policy depends on the source of stochastic disturbances affecting the economy, much as in the literature pioneered by Poole (1970). Optimal monetary policy reacts to domestic and foreign disturbances. If the intertemporal elasticity of substitution in consumption is less than one, as is likely to be the case empirically, the optimal exchange rate policy implies a dirty float: interest rate shocks from abroad are met partially by adjusting home interest rates, and partially by allowing the exchange rate to move. This optimal pattern may help rationalize the observed fear of floating.
Keywords: No keywords provided
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 interest rates (E43) | Productivity shocks (O49) |
| Domestic interest rates (E43) | Government spending shocks (E62) |
| Optimal monetary policy (E63) | Domestic disturbances (J12) |
| Optimal monetary policy (E63) | Foreign disturbances (F29) |
| Home interest rates (E43) | Interest rate shocks from abroad (E43) |
| Optimal exchange rate policy (F31) | 'Dirty float' (F31) |
| Optimal policy (C61) | Domestic welfare (I38) |