Optimal Monetary Policy in a Small Open Economy with Home Bias

35 Pages Posted: 14 Jun 2006

See all articles by Ester Faia

Ester Faia

Goethe University Frankfurt; Kiel Institute for the World Economy; University of Angers - Centre d'Etudes Prospectives d'Economie Mathematique Appliquees a la Planification (CEPREMAP)

Tommaso Monacelli

Bocconi University - Department of Economics

Date Written: March 2006

Abstract

We analyze optimal monetary policy in a small open economy characterized by home bias in consumption. Peculiar to our framework is the application of a Ramsey-type analysis to a model of the recent open economy New Keynesian literature. We show that home bias in consumption is a sufficient condition for inducing monetary policy-makers of an open economy to deviate from a strategy of strict markup stabilization and contemplate some (optimal) degree of exchange rate stabilization. We focus on the optimal setting of policy both in the case in which firms set prices one period in advance as well as in the case in which firms set prices in a dynamic forward-looking fashion. While the first setup allows us to analytically highlight home bias as an independent source of equilibrium markup variability, the second setup allows us to study the effects of future expectations on the optimal policy problem and the effect of home bias on optimal inflation volatility. The latter, in particular, is shown to be related to the degree of trade openness in a U-shaped fashion, whereas exchange rate volatility is monotonically decreasing in openness.

Keywords: Optimal monetary policy, Ramsey planner, home bias, sticky prices

JEL Classification: E52, F41

Suggested Citation

Faia, Ester and Monacelli, Tommaso, Optimal Monetary Policy in a Small Open Economy with Home Bias (March 2006). CEPR Discussion Paper No. 5522. Available at SSRN: https://ssrn.com/abstract=908567

Ester Faia (Contact Author)

Goethe University Frankfurt ( email )

Grüneburgplatz 1
Frankfurt am Main, 60323
Germany

Kiel Institute for the World Economy

P.O. Box 4309
Kiel, D-24100
Germany

University of Angers - Centre d'Etudes Prospectives d'Economie Mathematique Appliquees a la Planification (CEPREMAP)

Ecole Normale Superieure
48 boulevard Jourdan
75014 Paris
France

Tommaso Monacelli

Bocconi University - Department of Economics ( email )

Via Gobbi 5
Milan, 20136
Italy

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