Monetary Policy and Exchange Rate Volatility in a Small Open Economy
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.
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. citation courtesy of