Discussion Paper Details

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Title: Monetary Policy and Exchange Rate Volatility in a Small Open Economy

Author(s): Jordi Galí and Tommaso Monacelli

Publication Date: April 2002

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

Programme Area(s): International Macroeconomics

Abstract: 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.

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Bibliographic Reference

Galí, J and Monacelli, T. 2002. 'Monetary Policy and Exchange Rate Volatility in a Small Open Economy'. London, Centre for Economic Policy Research.