Monetary Policy and Exchange Rate Volatility in a Small Open Economy

UPF Economics and Business Working Paper 835

39 Pages Posted: 29 Nov 2005

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: July 2004

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 simple representation in domestic inflation and the output gap. We use the resulting framework to analyze the macroeconomic implications of three alternative rule-based policy regimes for the small open economy: domestic inflation and CPI-based Taylor rules, 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 the suboptimal rules.

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 (July 2004). Available at SSRN: https://ssrn.com/abstract=859564 or http://dx.doi.org/10.2139/ssrn.859564

Jordi Gali (Contact Author)

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

Ramon Trias Fargas, 25-27
Barcelona, 08005
Spain
+34 93 542 2754 (Phone)
+34 93 542 1746 (Fax)

HOME PAGE: http://www.econ.upf.es/~gali

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

50 Memorial Drive
Cambridge, MA 02142
United States

Centre for Economic Policy Research (CEPR)

London
United Kingdom

National Bureau of Economic Research (NBER)

1050 Massachusetts Avenue
Cambridge, MA 02138
United States

Tommaso Monacelli

Bocconi University - Department of Economics ( email )

Via Gobbi 5
Milan, 20136
Italy

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