Monetary Policy and Exchange Rate Volatility in a Small Open Economy

   (743 K)

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 monetary policy regimes for the small open economy: domestic inflation targeting, CPI targeting 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 suboptimal regimes.

Published: Gali, Jordi and Tommaso Monacelli. "Monetary Policy And Exchange Rate Volatility In A Small Open Economy," Review of Economic Studies, 2005, v72(252,Jul), 707-734.

This paper is available as PDF (743 K) or via email.

Machine-readable bibliographic record - MARC, RIS, BibTeX