Exchange Rate Dynamics and Monetary Policy in a Small Open Economy: A DSGE Model

Abstract

This paper compares alternative monetary policy rules in a small open economy that experiences internal shocks (productivity shocks) and external shocks to terms of trade and the foreign demand. A comparison of the volatility of the macroeconomic variables such as inflation, output, terms of trade, trade balance, investment and exchange rates under the different monetary rules is set to lead to the choice of the optimal exchange rate regime. I will show that these regimes can be ranked in terms of their implied volatility for the considered macroeconomic variables.  A two-country version of the Calvo sticky price model is used to analyze the macroeconomic implications of four alternative monetary policy regimes for a small open economy: domestic inflation targeting, managed float, CPI targeting and an exchange rate peg. The degree of exchange rate pass-through is very important for the assessment of monetary rules. I find that the CPI targeting rule is the best policy (from a macroeconomic stability viewpoint) in an economy that exhibits lagged exchange rate pass-through. With low pass-through, both the domestic and the overall prices respond sluggishly to shocks, and it is more efficient for the monetary authority to target the overall CPI rather than just domestic prices. In a low pass-through environment, the policy maker can simultaneously strictly target (CPI) inflation, but still allow high volatility in the nominal exchange rate to stabilize the real economy in face of shocks. The low rate of pass-through ensures that exchange rate shocks do not destabilize the price level. An important feature of low pass-through is that it eliminates the trade-off between output volatility and inflation volatility in the comparison of fixed relative to floating exchange rates.

Keywords: Exchange rate dynamics, the law of one price deviations, DSGE Models, Impulse Responses