Monetary Policy and Exchange Rate Volatility in a Small Open Economy

45 Pages Posted: 18 Apr 2002 Last revised: 2 Nov 2022

See all articles by Jordi Galí

Jordi Galí

Universitat Pompeu Fabra - Centre de Recerca en Economia Internacional (CREI); Massachusetts Institute of Technology (MIT) - Department of Economics; Centre for Economic Policy Research (CEPR); National Bureau of Economic Research (NBER)

Tommaso Monacelli

Bocconi University - Department of Economics

Multiple version iconThere are 3 versions of this paper

Date Written: April 2002

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.

Suggested Citation

Gali, Jordi and Monacelli, Tommaso, Monetary Policy and Exchange Rate Volatility in a Small Open Economy (April 2002). NBER Working Paper No. w8905, Available at SSRN: https://ssrn.com/abstract=307875

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Massachusetts Institute of Technology (MIT) - Department of Economics ( email )

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Centre for Economic Policy Research (CEPR)

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Tommaso Monacelli

Bocconi University - Department of Economics ( email )

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