Monetary Policy and Exchange Rate Volatility in a Small Open Economy

• Authors: Jordi Galí.
• BSE Working Paper: 112389 | September 15
• Keywords: Small open economy , optimal monetary policy , sticky prices , exchange rate peg , exchange rate volatility
• JEL codes: E52, F41
• Small open economy
• optimal monetary policy
• sticky prices
• exchange rate peg
• exchange rate volatility

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 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 those suboptimal rules.