Monetary Policy and Exchange Rate Volatility in a Small Open Economy

This paper builds a tractable, microfounded small open economy version of the Calvo staggered-price New Keynesian model – one economy among a continuum making up the world – and uses it to analyze rule-based monetary policy. Its first main result is that, under complete international asset markets and the paper’s specific preference and technology assumptions, the economy’s log-linearized equilibrium dynamics reduce to exactly the same two-equation “canonical” system used to study closed economies: a New Keynesian Phillips curve linking domestic (producer) inflation to the output gap, and a forward-looking dynamic IS equation, with openness and cross-country substitutability entering only through composite coefficients and world output entering only through the natural rate of interest. Its second main result, obtained for the special case of log utility and unit elasticities of substitution, is that once an appropriately chosen employment subsidy neutralizes both firms’ market power and the small open economy’s incentive to manipulate its terms of trade, the welfare-optimal policy is to fully stabilize domestic prices – strict domestic inflation targeting. The paper then uses a calibrated version of the model to compare this optimal benchmark with two simple, more standard policy rules (a domestic-inflation-based Taylor rule and a CPI-inflation-based Taylor rule) and an exchange rate peg, finding a systematic trade-off: regimes that stabilize domestic inflation and the output gap most successfully necessarily generate substantially more volatile nominal exchange rates and terms of trade, and vice versa, with the exchange rate peg delivering the worst welfare outcome of the three simple rules because its “excess smoothness” of the terms of trade – consistent with the Mussa (1986) puzzle – amplifies domestic inflation and output-gap volatility instead.

Tommaso Monacelli | Macro Paper Warehouse

Monetary Policy and Exchange Rate Volatility in a Small Open Economy