Working Paper: NBER ID: w8905
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 analyze 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: Monetary Policy; Exchange Rate Volatility; Small Open Economy
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) | Greater exchange rate volatility (F31) |
| CPI targeting (E31) | Lower exchange rate volatility (F31) |
| Exchange rate peg (F31) | Lower exchange rate volatility (F31) |
| Domestic inflation targeting (E31) | Higher nominal and real exchange rate volatility (F31) |
| CPI targeting dominates exchange rate peg from a welfare perspective (F31) | Optimality of domestic inflation targeting under certain parameterizations (E61) |