Monetary Policy and Exchange Rate Volatility in a Small Open Economy

47 Pages Posted: 4 Jun 2002

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 analyse 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: Small open economy, optimal monetary policy, sticky prices, exchange rate peg, exchange rate volatility

JEL Classification: E52, F41

Suggested Citation

Gali, Jordi and Monacelli, Tommaso, Monetary Policy and Exchange Rate Volatility in a Small Open Economy (April 2002). Available at SSRN: https://ssrn.com/abstract=315041

Jordi Gali (Contact Author)

Universitat Pompeu Fabra - Centre de Recerca en Economia Internacional (CREI) ( email )

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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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National Bureau of Economic Research (NBER)

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Tommaso Monacelli

Bocconi University - Department of Economics ( email )

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