2002-05 EC: Monetary Policy Analysis in a Small Open Economy with Incomplete Asset Markets (working paper)
published: 2002 | Research publication | Working Paper - Economics
ABSTRACT: This paper develops a dynamic stochastic general equilibrium monetary model of a small open economy with incomplete asset markets, nominal price rigidities and market imperfections that is used as a vehicle to study and compare alternative monetary policy rules. In the recent literature, similar open economy models ignore the dynamic relation between the exchange rate and net foreign asset accumulation by deemphasizing the role of the latter. Also, there is debate about how exchange rate should be taken into account in formulating monetary policy. This paper addresses these issues and explores its implications for monetary policy. The assumption of incomplete international asset markets is justified on two grounds: (1)- The complete markets assumption is not realistic. As Obstfeld and Rogoff (JPE, 1995) point out, that it would be strange to analyse imperfections and rigidities in goods markets but at the same time assume complete international asset markets. Moreover, the bonds-only formulation is more relevant since one of the objectives of this paper is to provide microfoundations for the Mundell-Fleming setup. (2)- With endogenous monetary policy, it is very appealing to explore the impact of changes in the monetary authority’s instrument (the nominal interest rate) and the exchange rate on net foreign asset accumulation. The main result of the paper is the breakdown of a widely accepted result reported by Clarida, Gali and Gertler (AER, 2001) in a similar model of a small open economy. They conjecture “under certain standard conditions, the optimal monetary policy design problem for the small open economy is isomorphic to the problem of closed economy considered earlier.” More specifically, the standard results that the central bank faces an inflation-output gap volatility trade-off only in the presence of cost-push shocks and that the aggregate demand shocks will be completely stabilized, do not hold in my model.
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revised Mar 7/05