Journal Article

Monetary Policy and Exchange Rate Volatility in a Small Open Economy

Jordi Galí and Tommaso Monacelli

in The Review of Economic Studies

Published on behalf of Review of Economic Studies Ltd

Volume 72, issue 3, pages 707-734
Published in print July 2005 | ISSN: 0034-6527
Published online July 2005 | e-ISSN: 1467-937X | DOI: http://dx.doi.org/10.1111/j.1467-937X.2005.00349.x
Monetary Policy and Exchange Rate Volatility in a Small Open Economy

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  • Macroeconomic Aspects of International Trade and Finance
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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 simple representation in domestic inflation and the output gap. We use the resulting framework to analyse 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: E52; F31; F41

Journal Article.  11893 words.  Illustrated.

Subjects: Macroeconomic Aspects of International Trade and Finance ; Monetary Policy, Central Banking, and the Supply of Money and Credit ; International Finance

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