DP3346 Monetary Policy and Exchange Rate Volatility in a Small Open Economy

Author(s): Jordi Galí , Tommaso Monacelli

Publication Date: April 2002

Keyword(s): small open economy , optimal monetary policy , sticky prices , exchange rate peg , exchange rate volatility

JEL(s): E52 , F41

Programme Areas: International Macroeconomics

Link to this Page: www.cepr.org/pubs/dps/DP3346.asp

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 analyse 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.