Monetary Policy, In‡ation,

and the Business Cycle

Chapter 7
Monetary Policy and the Open Economy

Jordi Galí y
CREI and UPF
August 2007

The present chapter is based on Galí and Monacelli (2005), with the notation modi…ed
somewhat for consistency with earlier chapters. The section on transmission of monetary
policy shocks contains original material.
y
Correspondence: Centre de Recerca en Economia Internacional (CREI); Ramon Trias
Fargas 25; 08005 Barcelona (Spain). E-mail: [email protected]
 All the models analyzed in earlier chapters assumed a closed economy:
households and …rms were not able to trade in goods or …nancial assets with
agents located in other economies. In the present chapter we relax that
assumption by developing an open economy extension of the basic new Key-
nesian model analyzed in chapter 3. Our framework introduces explicitly the
exchange rate, the terms of trade, exports and imports, as well as interna-
tional …nancial markets. It also implies a distinction between the consumer
price index–which includes the price of imported goods–, and the price in-
dex for domestically produced goods. Such a framework can in principle be
used to assess the implications of alternative monetary policy strategies in
an open economy. Since our framework nests as a limiting case the closed
economy model of chapter 3, it allows us to explore the extent to which the
opening of the economy a¤ects some of the conclusions regarding monetary
policy that we obtained for the closed economy model and, in particular, the
desirability of a policy that seeks to stabilize in‡ation (see chapter 4). We
can also analyze what role, if any, does the exchange rate play in the optimal
design of monetary policy and/or what is the measure of in‡ation that the
central bank should seek to stabilize. Finally, we can also use our framework
to determine the implications of alternative simple rules, as we did in chapter
4 for the closed economy.
The analysis of a monetary open economy raises a number of issues and
choices that a modeler needs to be confront, and which are absent from its
closed economy counterpart. First, a choice needs to be made between the
modelling of a "large" or a "small" economy, i.e. between allowing or not, re-
spectively, for repercussions in the rest of the world of developments (includ-
ing policy decisions) in the economy being modelled. Secondly, the existence
of two or more economies subject to imperfectly correlated shocks generates
an incentive to trade in assets between residents of di¤erent countries, in or-
der to smooth their consumption over time. Hence, a decision must be made
regarding the nature of international asset markets and, more speci…cally,
the set of securities that can be traded in those markets, with possible as-
sumptions ranging from …nancial autarky to complete markets. Thirdly, one
needs to make some assumption about …rms’ability to discriminate across
countries in the price they charge for the goods they produce ("pricing to
market" vs "law of one price"). Furthermore, whenever discrimination is
possible and prices are not readjusted continuously, an assumption must be
made regarding the currency in which the prices of exported goods are set
("local currency pricing"–when prices are set in the currency of the import-

1
ing economy–vs "producer currency pricing"–with prices set in the currency
of the producer’s country–). Other dimensions of open economy modelling
that require that some choices include the allowance of not for non-tradable
goods, the existence of trading costs, the possibility of international policy
coordination, etc.
A comprehensive analysis of those di¤erent modeling dimensions and how
they may a¤ect the design of monetary policy would require a book of its
own, and so it is clearly beyond the scope of the present chapter. Our more
modest objective here is to present an example of a monetary open economy
model to illustrate some of the issues that emerge in the analysis of such
economies and which are absent from their closed economy counterparts.
In particular, we develop a model of a small open economy, with complete
international …nancial markets, and where the law of one price holds. Then,
in the discussion of our model’s policy implications and in the notes on the
literature at the end of the chapter, we refer to a number of papers that adopt
di¤erent assumptions and brie‡y discuss the extent to which this leads their
…ndings to di¤er from ours.
The framework below, originally developed in Galí and Monacelli (2005),
models a small open economy as one among a continuum of (in…nitesimally
small) economies making up the world economy. For simplicity, and in or-
der to focus on the issues brought about by the openness of the economy
we ignore the possible presence of either cost-push shocks or nominal wage
rigidities. The assumptions on preferences and technology, combined with
the Calvo price-setting structure and the assumption of complete …nancial
markets, give rise to a highly tractable model and to simple and intuitive
log-linearized equilibrium conditions. The latter can be reduced to a two-
equation dynamical system consisting of a new Keynesian Phillips curve and
a dynamic IS-type equation, whose structure is identical to the one derived
in chapter 3 for the closed economy, though its coe¢ cients depend on para-
meters that are speci…c to the open economy, while the driving forces are a
function or world variables (which are taken as exogenous to the small open
economy). As in its closed economy counterpart, the two equations must be
complemented with a description of how monetary policy is conducted.
After describing the model and deriving a simple representation of its
equilibrium dynamics, in section 3 we analyze the transmission of monetary
policy shocks, emphasizing the role played by openness in that transmission.
In section 4 we turn to the issue of optimal monetary policy design, focusing
on a particular case for which the ‡exible price allocation is e¢ cient. Under

2
the same assumptions it is straightforward to derive a second order approx-
imation to the consumer’s utility, which can be used to evaluate alternative
policy rules. We put it to work in section 5, where we assess the merits of
two di¤erent Taylor-type rules, a policy that fully stabilizes the CPI, and an
exchange rate peg. As in previous chapters, the last section concludes with
a brief note on the related literature.

1 A Small Open Economy Model

We model the world economy as a continuum of small open economies rep-
resented by the unit interval. Since each economy is of measure zero, its
performance does not have any impact on the rest of the world. Di¤erent
economies are subject to imperfectly correlated productivity shocks, but we
assume they share identical preferences, technology, and market structure.
Next we describe in detail the problem facing households and …rms lo-
cated in one such economy. Before we do so, a brief remark on notation
is in order. Since our focus is on the behavior of a single economy and its
interaction with the world economy, and in order to lighten the notation, we
use variables without an i-index to refer to the small open economy being
modeled. Variables with an i 2 [0; 1] subscript refer to economy i, one among
the continuum of economies making up the world economy. Finally, variables
with a star superscript correspond to the world economy as a whole.

1.1 Households
A typical small open economy is inhabited by a representative household who
seeks to maximize
X1
t
E0 U (Ct ; Nt ) (1)
t=0

where Nt denotes hours of labor, and Ct is a composite consumption index

de…ned by
h 1 1 1 1
i 1
Ct (1 ) (CH;t ) + (CF;t ) (2)
where CH;t is an index of consumption of domestic goods given by the CES
function Z 1 1
1
CH;t CH;t (j) dj
0

3
where j 2 [0; 1] denotes the good variety.1 CF;t is an index of imported goods
given by
Z 1 1
1
CF;t (Ci;t ) di
0

where Ci;t is, in turn, an index of the quantity of goods imported from country
i and consumed by domestic households. It is given by an analogous CES
function: Z 1 1
1
Ci;t Ci;t (j) dj
0

Note that parameter > 1 denotes the elasticity of substitution between

varieties produced within any given country.2 Parameter 2 [0; 1] can be
interpreted as a measure of openness.3 Parameter > 0 measures the sub-
stitutability between domestic and foreign goods, from the viewpoint of the
domestic consumer, while measures the substitutability between goods pro-
duced in di¤erent foreign countries.
Maximization of (1) is subject to a sequence of budget constraints of the
form:
Z 1 Z 1Z 1
PH;t (j) CH;t (j) dj+ Pi;t (j) Ci;t (j) dj di +Et fQt;t+1 Dt+1 g Dt +Wt Nt +Tt
0 0 0
(3)
for t = 0; 1; 2; :::, where PH;t (j) is the price of domestic variety j: Pi;t (j) is
the price of variety j imported from country i. Dt+1 is the nominal payo¤
in period t + 1 of the portfolio held at the end of period t (and which in-
cludes shares in …rms), Wt is the nominal wage, and Tt denotes lump-sum
transfers/taxes. The previous variables are all expressed in units of domestic
1
As discussed below, each country produces a continuum of di¤erentiated goods, rep-
resented by the unit interval.
2
Notice that it is irrelevant whether we think of integrals like the one in (2) as including
or not the corresponding variable for the small economy being modeled, since its presence
would have a negligible in‡uence on the integral itself (in fact each individual economy has
a zero measure). The previous remark also applies to many other expressions involving
integrals over the continuum of economies (i.e., over i) that the reader will encounter
below.
3
Equivalently, 1 is a measure of the degree of home bias. Note that in the absence of
some home bias the households in our small open economy would attach an in…nitesimally
small weight to local goods, and consumption expenditures would be allocated to imported
goods (except for a in…nitesimally small share allocated to domestic goods).

4
currency. Qt;t+1 is the stochastic discount factor for one-period ahead nomi-
nal payo¤s relevant to the domestic household. We assume that households
have access to a complete set of contingent claims, traded internationally.
The optimal allocation of any given expenditure within each category of
goods yields the demand functions:
PH;t (j) Pi;t (j)
CH;t (j) = CH;t ; Ci;t (j) = Ci;t (4)
PH;t Pi;t
R1 1 1
1

for all i; j 2 [0; 1], where PH;t 0

P H;t (j) dj is the domestic price
index (i.e., an index of prices of domestically produced goods) and Pi;t
R1 1 1
1

0
P i;t (j) dj is a price index for goods imported from country i (ex-
pressed in domestic currency), for all i 2 [0; 1]. Combining the optimality
conditions in (4), with the de…nitions of price and quantity indexes PH;t ,
R1 R1
CH;t , Pi;t and Ci;t we obtain 0 PH;t (j) CH;t (j) dj = PH;t CH;t and 0 Pi;t (j)
Ci;t (j) dj = Pi;t Ci;t .
Furthermore, the optimal allocation of expenditures on imported goods
by country of origin implies:

Pi;t
Ci;t = CF;t (5)
PF;t
R1 1 1
1

for all i 2 [0; 1], and where PF;t 0

Pi;t di is the price index
for imported goods, also expressed in domestic currency. Note that (5),
together with the de…nitions of PF;t and CF;t implies that we can write total
R1
expenditures on imported goods as 0 Pi;t Ci;t di = PF;t CF;t .
Finally, the optimal allocation of expenditures between domestic and im-
ported goods is given by:
PH;t PF;t
CH;t = (1 ) Ct ; CF;t = Ct (6)
Pt Pt
1
where Pt [(1 ) (PH;t )1 + (PF;t )1 ] 1 is the consumer price index
4
(CPI). Note that under the assumption of = 1 or, alternatively, when
4
It is usefult to notice, for future reference, that in the particular case of = 1,
the CPI takes the form Pt = (PH;t )1 (PF;t ) , while the consumption index is given by
Ct = (1 )(11 ) CH;t 1 CF;t

5
the price indexes for domestic and foreign goods are equal (as in the steady
state described below), parameter corresponds to the share of domestic
consumption allocated to imported goods. It is also in this sense that
represents a natural index of openness.
Accordingly, total consumption expenditures by domestic households are
given by PH;t CH;t + PF;t CF;t = Pt Ct . Thus, the period budget constraint can
be rewritten as:

Pt Ct + Et fQt;t+1 Dt+1 g Dt + Wt Nt + Tt (7)

As in previous chapters we specialize the period utility function to be

C1 N 1+'
of the form U (C; N ) 1 1+'
. Thus we can rewrite the remaining
optimality conditions for the household’s problem as follows:
Wt
Ct Nt' = (8)
Pt
which is the standard intratemporal optimality condition. In order to de-
rive the relevant intertemporal optimality condition note that the following
relation must hold for the optimizing household in our small open economy:
Vt;t+1 1
Ct = t;t+1 Ct+1 (9)
Pt Pt+1
where Vt;t+1 is the period t price (in domestic currency) of an Arrow security,
i.e. a one-period security that yields one unit of domestic currency if a
speci…c state of nature is realized in period t + 1, and nothing otherwise,
and where t;t+1 is the probability of that state of nature being realized in
t + 1 (conditional on the state of nature at t). Variables Ct+1 and Pt+1 on
the right hand side should be interpreted as representing the values taken
by the consumption index and the CPI at t + 1 conditional on the state of
nature to which the Arrow security refers being realized. Thus, the left hand
side captures the utility loss resulting from the purchase of an Arrow security
considered (with the corresponding reduction in consumption), whereas the
right hand side measures the expected one-period-ahead utility gain from the
additional consumption made possible by the (eventual) security payo¤. If
the consumer is optimizing the expected utility gain must exactly o¤set the
current utility loss.
Given that the price of Arrow securities and the one period stochastic
discount factor are related by the equation Qt;t+1 Vt;t+1 we can rewrite (9)
t;t+1

6
as:5

Ct+1 Pt
= Qt;t+1 (10)
Ct Pt+1
which is assumed to be satis…ed for all possible states of nature at t and t+1.
Taking conditional expectations on both sides of (10) and rearranging
terms we obtain a conventional stochastic Euler equation:
( )
Ct+1 Pt
Qt = Et (11)
Ct Pt+1
where Qt Et fQt;t+1 g denotes the price of a one-period discount bond pay-
ing o¤ one unit of domestic currency in t + 1.
For future reference, we recall that (8) and (11) can be respectively writ-
ten in log-linearized form as:

wt pt = ct + ' nt
1
ct = Et fct+1 g (it Et f t+1 g ) (12)
where lower case letters denote the logs of the respective variables, it
log Qt is the short-term nominal rate, log is the time discount
rate, and t pt pt 1 is CPI in‡ation (with pt log Pt ).

1.1.1 Domestic In‡ation, CPI In‡ation, the Real Exchange Rate,

and the Terms of Trade: Some Identities
Next we introduce several assumptions and de…nitions, and derive a number
of identities that are extensively used below. We start by de…ning the bilateral
Pi;t
terms of trade between the domestic economy and country i as Si;t = PH;t ,
i.e. the price of country i’s goods in terms of home goods. The e¤ective
5
Note that under complete markets a simple no room for arbitrage argument implies
that the price
P of a one-period asset (or portfolio) yielding a random payo¤ Dt+1 must be
given by Vt;t+1 Dt+1 where
n the sum ois over all possible t + 1 states. Equivalently, we
Vt;t+1
can write that price as Et Dt+1 . We can thus de…ne the one period stochastic
t;t+1
Vt;t+1
discount factor as Qt;t+1 .
t;t+1

7
terms of trade are thus given by
PF;t
St
PH;t
Z 1 1
1

1
= Si;t di
0

which can be approximated (up to …rst order) around a symmetric steady

state satisfying Si;t = 1 for all i 2 [0; 1] by
Z 1
st = si;t di (13)
0

where st log St = pF;t pH;t .

Similarly, log-linearization of the CPI formula around the same symmetric
steady state yields:

pt (1 ) pH;t + pF;t
= pH;t + st (14)

It is useful to note, for future reference, that (13) and (14) hold exactly
when = 1 and = 1, respectively.
It follows that domestic in‡ation – de…ned as the rate of change in the
index of domestic goods prices, i.e., H;t pH;t+1 pH;t –and CPI-in‡ation
are linked according to the relation:

t = H;t + st (15)
which makes the gap between our two measures of in‡ation proportional to
the percent change in the terms of trade, with the coe¢ cient of proportion-
ality given by the openness index .
We assume that the law of one price holds for individual goods at all
i
times (both for import and export prices), implying that Pi;t (j) = Ei;t Pi;t (j)
for all i; j 2 [0; 1], where Ei;t is the bilateral nominal exchange rate (the price
i
of country i’s currency in terms of the domestic currency), and Pi;t (j) is the
price of country i’s good j expressed in terms of its own currency. Plugging
the previous assumption into the de…nition of Pi;t one obtains Pi;t = Ei;t
i i
R1 i 1 1
1

Pi;t , where Pi;t 0

P i;t (j) dj is country i’s domestic price index. In

8
turn, by substituting into the de…nition of PF;t and log-linearizing around
the symmetric steady state we obtain:
Z 1
pF;t = (ei;t + pii;t ) di
0
= et + pt
R1 i
where pii;t p (j) dj is the (log) domestic price index for country i (ex-
0 i;t R1
pressed in terms of its own currency), et e di is the (log) e¤ective
0 i;t
R1 i
nominal exchange rate, and pt p di is the (log) world price index.
0 i;t
Notice that for the world as a whole there is no distinction between CPI and
domestic price level, nor between their corresponding in‡ation rates.
Combining the previous result with the de…nition of the terms of trade
we obtain the following expression:

st = et + pt pH;t (16)

Next, we derive a relationship between the terms of trade and the real
exchange rate. First, we de…ne the bilateral real exchange rate with country
Ei;t Pti
i as Qi;t Pt
, i.e., the ratio of the two countries CPIs, both expressed
R1
in terms of domestic currency. Let qt q di be the (log) e¤ective real
0 i;t
exchange rate, where qi;t log Qi;t . It follows that
Z 1
qt = (ei;t + pit pt ) di
0
= et + pt pt
= st + pH;t pt
= (1 ) st

where the last equality holds only up to a …rst order approximation when
6= 1.6
h i11
6
The last equality can be derived by log-linearizing Pt
PH;t = (1 )+ St1
around a symmetric steady state, which yields

pt pH;t = st

9
1.1.2 International Risk Sharing
Under the assumption of complete markets for securities traded international,
a condition analogous to (9) must also hold for the representative household
in any other country, say country i:
Vt;t+1 1
i i
(Cti ) = t;t+1
i
(Ct+1 ) i i
Et Pt Et+1 Pt+1
where the presence of the exchange rate terms re‡ect the fact that the security
purchased by the country i’s household has a price Vt;t+1 and a unit payo¤
expressed in the currency of the small open economy of reference, and hence
need to be converted to country i’s currency.
We can write the previous relation in terms of our small open economy’s
stochastic discount factor as follows:
i
Ct+1 Pti Eti
= Qt;t+1 (17)
Cti i
Pt+1 i
Et+1
Combining (10) and (17), together with the de…nition for the real ex-
change rate de…nition we have:
1
Ct = #i Cti Qi;t (18)
for all t, and where #i is a constant which will generally depend on initial
conditions regarding relative net asset positions. Henceforth, and without
loss of generality, we assume symmetric initial conditions (i.e., zero net for-
eign asset holdings and an ex-ante identical environment), in which case we
have #i = # = 1 for all i.
Taking logs on both sides of (18) and integrating over i we obtain

1
ct = ct + qt (19)
1
= ct + st
R1 i
where ct c di is our index for world consumption (in log terms), and
0 t
where the second equality holds only up to a …rst order approximation when
6= 1. Thus we see that the assumption of complete markets at the interna-
tional level leads to a simple relationship linking domestic consumption with
world consumption and the terms of trade.

10
1.1.3 A Brief Detour: Uncovered Interest Parity and the Terms
of Trade
Under the assumption of complete international …nancial markets, the equi-
librium price (in terms of our small open economy’s domestic currency) of
a riskless bond denominated in country i’s currency is given by Ei;t Qit =
Et fQt;t+1 Ei;t+1 g, where Qit is the price of the bond in terms of country i’s
currency. The previous pricing equation can be combined with the domestic
bond pricing equation, Qt = Et fQt;t+1 g to obtain a version of the uncovered
interest parity condition:

Et fQt;t+1 [expfit g expfit g (Ei;t+1 =Ei;t )]g = 0

Log-linearizing around a perfect-foresight steady state, and aggregating

over i, yields the familiar expression:

it = it + Et f et+1 g (20)

Combining the de…nition of the (log) terms of trade with (20) yields the
following stochastic di¤erence equation:

st = (it Et f t+1 g) (it Et f H;t+1 g) + Et fst+1 g (21)

As we show in the appendix, the terms of trade are pinned down uniquely
in the perfect foresight steady state. That fact, combined with our assump-
tion of stationarity in the model’s driving forces and unit relative prices in
the steady state, implies that limT !1 Et fsT g = 0.7 Hence, we can solve (21)
forward to obtain:
(1 )
X
st = Et [(it+k t+k+1 ) (it+k H;t+k+1 )] (22)
k=0

i.e., the terms of trade are a function of current and anticipated real interest
rate di¤erentials.
7
Our assumption regarding the steady state implies that real interest rate di¤erential
will revert to a zero mean. More generally, the real interest rate di¤erential will revert to
a constant mean, as long as the terms of trade are stationary in …rst di¤erences. That
would be the case if, say, the technology parameter had a unit root or a di¤erent average
rate of growth relative to the rest of the world. In those cases we could have persistent
real interest rate di¤erentials.

11
 We must point out that while equation (21) (and (22)) provides a con-
venient (and intuitive) way of representing the connection between terms
of trade and interest rate di¤erentials, it does not constitute an additional
independent equilibrium condition. In particular, it is easy to check that
(21) can be derived by combining the consumption Euler equations for both
the domestic and world economies with the risk sharing condition (19) and
equation (15).
Next we turn our attention to the supply side of the economy.

1.2 Firms
1.2.1 Technology
A typical …rm in the home economy produces a di¤erentiated good with a
linear technology represented by the production function

Yt (j) = At Nt (j)

where at log At follows the AR(1) process at = a at 1 + "t , and where

j 2 [0; 1] is a …rm-speci…c index.8
Hence, the real marginal cost (expressed in terms of domestic prices) will
be common across domestic …rms and given by

mct = + wt pH;t at

where log(1 ), with being an employment subsidy whose role is

discussed later in more detail.

1.2.2 Price Setting

As in the basic model of chapter 3, we assume that …rms set prices in a
staggered fashion, as in Calvo (1983). Hence, a measure 1 of (randomly
selected) …rms sets new prices each period, with an individual …rm’s prob-
ability of re-optimizing in any given period being independent of the time
elapsed since it last reset its price. As shown in chapter 3, the optimal price-
setting strategy for the typical …rm resetting its price in period t can be
approximated by the (log-linear) rule:
8
An extension of our analysis to the case of decreasing returns considered in shapter
3 is straightforward. In order to keep the notation as simple as possible we restrict the
analysis here to the case of constant returns.

12
 X
1
pH;t = + (1 ) ( )k Et fmct+k + pH;t g (23)
k=0

where pH;t denotes the (log) of newly set domestic prices, and log 1
is the log of the (gross) markup in the steady state (or, equivalently, the
equilibrium markup in the ‡exible price economy).9

2 Equilibrium
2.1 Aggregate Demand and Output Determination
2.1.1 Consumption and Output in the Small Open Economy
Goods market clearing in the home economy requires

Z 1
i
Yt (j) = CH;t (j) + CH;t (j) di (24)
0
" Z ! #
1 i
PH;t (j) PH;t PH;t PF;t
= (1 ) Ct + i
Cti di
PH;t Pt 0 Ei;t PF;t Pti

i
for all j 2 [0; 1] and all t, where CH;t (j) denotes country i’s demand for good j
produced in the home economy. Notice that the second equality has made use
of (6) and (5) together with our assumption of symmetric preferences across
i
PF;t
i PH;t (j) PH;t
countries, which implies CH;t (j) = PH;t i
Ei;t PF;t Pti
Cti .
Plugging (24) into the de…nition of aggregate domestic output Yt
9
We use pH;t to denote newly set prices instead of pt (used in chapter 3) , since in the
present chapter we reserve letters with an asterisk to refer to world economy variables.

13
hR i
1 1 1
0
Yt (j)1 dj we obtain:

Z !
1 i
PH;t PH;t PF;t
Yt = (1 ) Ct + i
Cti di
Pt 0 Ei;t PF;t Pti
" Z #
1 i
PH;t Ei;t PF;t
= (1 ) Ct + Qi;t Cti di
Pt 0 PH;t
Z 1
PH;t 1
= Ct (1 )+ Sti Si;t Qi;t di (25)
Pt 0

where the last equality follows from (18), and where Sti denotes the e¤ective
terms of trade of country i, while Si;t denotes the bilateral terms of trade be-
tween the home economy and foreign country i. Notice that in the particular
case of = = = 1 the previous condition can be written exactly as10

Yt = Ct St (26)
R1
More generally, and recalling that 0 sit di = 0, we can derive the follow-
ing …rst-order log-linear approximation to (25) around the symmetric steady
state:
1
yt = ct + st + qt
!
= ct + st (27)

where ! + (1 )( 1). Notice that = = = 1 implies ! = 1.

A condition analogous to the one above will hold for all countries. Thus,
for a generic country i it can be rewritten as yti = cit + ! sit . By aggregating
over all countries we can derive a world market clearing condition as follows

Z 1
yt yti di (28)
0
Z 1
= cit di ct
0
10
Here one must use the fact that under the assumption = 1, the CPI takes the form
PF;t
Pt = (PH;t )1 (PF;t ) thus implying PPH;t
t
= PH;t = St :

14
where yt and ct are indexes for world output and consumption (in log terms),
R1
and where the main equality follows, once again, from the fact that 0 sit
di = 0.
Combining (27) with (19) and (28), we obtain:
1
yt = yt + st (29)

where 1+ (! 1)
> 0.
Finally, combining (27) with Euler equation (12), we get:

1 !
yt = Et fyt+1 g (it Et f t+1 g ) Et f st+1 g (30)
1
= Et fyt+1 g (it Et f H;t+1 g ) Et f st+1 g
1
= Et fyt+1 g (it Et f H;t+1 g )+ Et f yt+1 g

where ( 1) + (1 )( 1) = ! 1. Not that, in general, the

degree of openness in‡uences the sensitivity of output to any given change
in the domestic real rate it Et f H;t+1 g, given world output. In particular,
if > 0 (i.e., for relatively high values of and ), an increase in openness
raises that sensitivity (i.e. is smaller). The reason is the direct negative
e¤ect of an increase in the real rate on aggregate demand and output is
ampli…ed by the induced real appreciation (and the consequent switch of
expenditure towards foreign goods). This will be partly o¤set by any increase
in CPI in‡ation relative to domestic in‡ation induced by the expected real
depreciation, which would dampen the change in the consumption-based real
rate it Et f t+1 g–which is the one ultimately relevant for aggregate demand–,
relative to it Et f H;t+1 g.

2.1.2 The Trade Balance

1
Let nxt Y
Yt PPH;tt
Ct denote net exports in terms of domestic out-
put, expressed as a fraction of steady state output Y . In the particular case
of = = = 1, it follows from (25) that PH;t Yt = Pt Ct for all t, thus
implying a balanced trade at all times. More generally, a …rst-order approxi-
mation yields nxt = yt ct st which combined with (27) implies a simple

15
relation between net exports and the terms of trade:
!
nxt = 1 st (31)

Again, in the special case of = = = 1 we have nxt = 0 for

all t, though the latter property will also hold for any con…guration of those
parameters satisfying ( 1)+(1 )( 1) = 0. More generally, the sign
of the relationship between the terms of trade and net exports is ambiguous,
depending on the relative size of , , and .

2.2 The Supply Side: Marginal Cost and In‡ation Dy-

namics
2.2.1 Aggregate Output and Employment
hR i 1
1 1 1
Let Yt 0 t
Y (j) dj represent an index for aggregate domestic out-
put, analogous to the one introduced for consumption. As in chapter 3, we
can derive an approximate aggregate production function relating the previ-
ous index to aggregate employment. Hence, notice that
Z 1 Z 1
Yt Pt (j)
Nt Nt (j) dj = dj
0 At 0 Pt
R 1 Pt (j)
As shown in chapter 3, however, variations in dt 0 Pt
dj around
the perfect foresight steady state are of second order. Thus, and up to a …rst
order approximation, the following relationship between aggregate output
and employment holds

y t = at + n t (32)

2.2.2 Marginal Cost and In‡ation Dynamics in the Small Open

Economy
As it was shown in chapter 3, the (log-linearized) optimal price-setting con-
dition (23) can be combined with the (log linearized) di¤erence equation
describing the evolution of domestic prices (as a function of newly set prices)

16
to yield an equation determining domestic in‡ation as a function of deviations
of marginal cost from its steady state value:

H;t = Et f H;t+1 g + ct
mc (33)
(1 )(1 )
where . Thus, relationship (33) does not depend on any of
the parameters that characterize the open economy. On the other hand, the
determination of real marginal cost as a function of domestic output in the
open economy di¤ers somewhat from that in the closed economy, due to the
existence of a wedge between output and consumption, and between domestic
and consumer prices. Thus, in our model we have

mct = + (wt pH;t ) at

= + (wt pt ) + (pt pH;t ) at
= + ct + ' nt + st at
= + yt + ' yt + st (1 + ') at (34)

where the last equality makes use of (32) and (19). Thus, we see that marginal
cost is increasing in the terms of trade and world output. Both variables
end up in‡uencing the real wage, through the wealth e¤ect on labor supply
resulting from their impact on domestic consumption. In addition, changes
in the terms of trade have a direct e¤ect on the product wage, for any given
consumption wage. The in‡uence of technology (through its direct e¤ect on
labor productivity) and of domestic output (through its e¤ect on employment
and, hence, the real wage–for given output) is analogous to that observed in
the closed economy.
Finally, using (29) to substitute for st , we can rewrite the previous expres-
sion for the real marginal cost in terms of domestic output and productivity,
as well as world output:

mct = +( + ') yt + ( ) yt (1 + ') at (35)

In general, In the open economy, a change in domestic output has an
e¤ect on marginal cost through its impact on employment (captured by '),
and the terms of trade (captured by , which is a function of the degree
of openness and the substitutability between domestic and foreign goods).
World output, on the other hand, a¤ects marginal cost through its e¤ect on
consumption (and, hence, the real wage, as captured by ) and the terms of

17
trade (captured by ). Note that the sign of its impact on marginal cost is
ambiguous. Under the assumption of > 0 (i.e. high substitutability among
goods produced in di¤erent countries), we have > , implying that an
increase in world output raises the marginal cost. This is so because in that
case the size of the real appreciation needed to absorb the change in relative
supplies is small, with its negative e¤ects on marginal cost more than o¤set
by the positive e¤ect from a higher real wage. Notice that in the special
cases = 0 and/or = = = 1, which imply = , the domestic real
marginal cost is completely insulated from movements in foreign output.
How does the degree of openness a¤ect the sensitivity of marginal cost
and in‡ation to changes in domestic and world output? Note also that, under
the same assumption of high substitutability ( > 0) considered above, an
increase in openness reduces the impact of a change in domestic output on
marginal cost (and hence on in‡ation), for it lowers the size of the required
adjustment in the terms of trade. By the same token, it raises the positive
impact of a change in world output on marginal cost, by limiting the size of
the associated variation in the terms of trade and, hence, its countervailing
e¤ect.
Finally, and for future reference, we note that under ‡exible prices mct =
for all t. Thus, the natural level of output in our open economy is given
by
ytn = 0 + a at + yt (36)
v 1+'
where 0 +'
; a +'
> 0, and +'
. Note that the sign
of the e¤ect of world output on the domestic natural output is ambiguous,
depending on the sign of the e¤ect of the former on domestic marginal cost,
which in turn depends on the relative importance of the terms of trade e¤ect
discussed above.

2.3 Equilibrium Dynamics: A Canonical Representa-

tion
In this section we show that the linearized equilibrium dynamics for the small
open economy have a representation in terms of output gap and domestic
in‡ation analogous to its closed economy counterpart.
Let yet yt ytn denote the domestic output gap. Given (35) and the fact
that yt is invariant to domestic developments, it follows that the domestic
real marginal cost and the output gap are related according to:

18
 ct = (
mc + ') yet
We can combine the previous expression with (33) to derive a version of
the new Keynesian Phillips curve for the open economy:

H;t = Et f H;t+1 g + yet (37)

where ( + '). Notice that for = 0 (or = = = 1) the
slope coe¢ cient is given by ( + ') as in the standard, closed economy
new Keynesian Phillips curve. More generally, we see that the form of the
in‡ation equation for the open economy corresponds to that of the closed
economy, at least as far as domestic in‡ation is concerned. The degree of
openness a¤ects the dynamics of in‡ation only through its in‡uence on the
size of the slope of the Phillips curve, i.e., the size of the in‡ation response
to any given variation in the output gap. If > 0 (which obtains for “high”
values of and , i.e. under high substitutability of goods produced in
di¤erent countries), an increase in openness lowers , dampening the real
depreciation induced by an increase in domestic output and, as a result, the
e¤ect of the latter on marginal cost and in‡ation.
Using (30) it is straightforward to derive a version of the so-called dynamic
IS equation for the open economy in terms of the output gap:
1
yet = Et fe
yt+1 g (it Et f H;t+1 g rtn ) (38)

where
'
rtn a (1 a) at + Et f yt+1 g (39)
+'
is the small open economy’s natural rate of interest.
Thus we see that the small open economy’s equilibrium is characterized
by a forward looking IS-type equation similar to that found in the closed
economy. Two di¤erences can be pointed out, however. First, as discussed
above, the degree of openness in‡uences the sensitivity of the output gap to
interest rate changes. Secondly, openness generally makes the natural inter-
est rate depend on expected world output growth, in addition to domestic
productivity.

19
3 Equilibrium Dynamics under an Interest
Rate Rule
Next we analyze the equilibrium response of our small open economy to a
variety of shocks. In doing so we assume that the monetary authority follows
an interest rate rule of the form already assumed in chapter 3, namely

it = + H;t + y yet + vt (40)

where vt is an exogenous component, and where and y are non-negative
coe¢ cients, chosen by the monetary authority.
Combining (37), (38), and (40) we can represent the equilibrium dynamics
for the output gap and domestic in‡ation by means of the system of di¤erence
equations.

yet Et fe
yt+1 g
=A rtn
+ B (b vt ) (41)
H;t Et f t+1 g
where rbtn rtn , and

1 1
A ; BT
+ ( + y)

1
with + y+
. Note that the previous system takes the same form as
the one analyzed in chapter 3 for the closed economy, with the only di¤erence
lying in the fact that some of the coe¢ cients are a function of the "open
economy parameters" , , and , and that rbtn is now given by (39). In
particular, the condition for a locally unique stationary equilibrium under
rule (40) takes the same form as shown in chapter 3, namely

( 1) + (1 ) y >0 (42)

which we assume to hold for the remainder of the present section.

The next subsection uses the previous framework to examine the econ-
omy’s response to an exogenous monetary policy shock, i.e. an exogenous
change in vt . Given the isomorphism with the closed economy model of
chapter 4 we can exploit many of the results derived there.
The analysis of the e¤ects of a technology shock (or a change in world out-
put), which we do not pursue below, goes along the same lines as in chapter

20
3. First, we need to determine the implications of the shock considered for
the natural interest rate rbtn and then we proceed to solve for the equilibrium
response of the output gap and domestic in‡ation exactly as we do below for
the case of a monetary policy shock, given the symmetry with which vt and
rbtn enter the equilibrium conditions.11

3.0.1 The E¤ects of a Monetary Policy Shock

We assume that the exogenous component of the interest rate, vt , follows an
AR(1) process
vt = v vt 1 + "vt
where v 2 [0; 1).
The natural rate of interest is not a¤ected by a monetary policy shock
so we can set rbtn = 0, for all t for the purposes of the present exercise. As
in chapter 3, we guess that the solution takes the form yet = yv vt and
t = v vt , where yv and v are coe¢ cients to be determined. Imposing
the guessed solution on (??) and (??) and using the method of undetermined
coe¢ cients, we …nd:

yt = yet
= (1 v) v vt

and
H;t = v vt
1
where v (1
. It can be easily shown that as
v )[ (1 v )+ y ]+ ( v)
long as (42) is satis…ed we have v > 0. Hence, as in the closed economy,
an exogenous increase in the interest rate leads to a persistent decline in
output and in‡ation. The size of the e¤ect of the shock relative to the closed
economy benchmark depends on the values taken by a number of parameters.
More speci…cally, if the degree of substitutability among goods produced in
di¤erent countries is high (i.e. if and are high, so that ! > 1) then v
can be shown to be increasing in the degree of openness, thus implying that
a given monetary policy shock will have a larger impact in the small open
economy than in its closed economy counterpart.
11
Of course, as in chapter 3, we need to take into account that a technology shock or
a shock to world output also lead to a variation in the natural outpt level, thus breaking
the identity between output and the output gap.

21
 Using interest rate rule (40) we can determine the response of the nominal
rate, taking into account the central bank’s endogenous reaction to changes
in in‡ation and the output gap:
it = 1 v( + y (1 v )) vt
Note that as in the closed economy model, the full response of the nom-
inal rate may be positive or negative, depending on parameter values. The
response of the real interest rate (expressed in terms of domestic goods) is
given by
rt = it Et f H;t+1 g
= 1 v (( v) + y (1 v )) vt
which can be shown to increase when vt rises (since the term in square brack-
ets is unambiguously positive).
Using (29) we can uncover the response of the terms of trade to the
monetary policy shock:
st = yt
= (1 v) v vt
The change in the nominal exchange rate is given in turn by
et = st + H;t
= (1 v) v vt v vt
Thus, a monetary policy contraction leads to an improvement in the terms
of trade (i.e. an decrease in the relative price of foreign goods) and a nominal
exchange rate appreciation.
Note that, in the long run, the terms of trade revert back to their origi-
nal level in response to the monetary policy shock, while the (log) levels of
both domestic prices and the nominal exchange rate experience a permanent
change of size 1 v (given an initial shock of size normalized to unity).
v
Hence, the exchange rate will overshoot its long-run level in response to
the monetary policy shock if and only if
(1 v )(1 v) > v

which requires that the shock is not too persistent. It can be easily shown
that the previous condition corresponds to that for an increase in the nominal

22
interest rate in response to a positive vt shock. Note that, in that case,
the subsequent exchange rate depreciation required by the interest parity
condition (20) leads to an initial overshooting.

4 Optimal Monetary Policy: A Special Case

In this section we derive and characterize the optimal monetary policy for the
small open economy described above, as well as the implications of that policy
for a number of macroeconomic variables. The analysis, which follows closely
that of Galí and Monacelli (2005), is restricted to a special case for which
a second order approximation to the welfare of the representative consumer
can be easily derived analytically. Its conclusions should thus not be taken
as applying to a more general environment. Instead we present the exercise
as an illustration of our approach to optimal monetary design to an open
economy.
Let us take as a benchmark the basic new Keynesian model developed in
chapter 3. As discussed in that chapter, under the assumption of a constant
employment subsidy that neutralizes the distortion associated with …rms’
market power, the optimal monetary policy is the one that replicates the
‡exible price equilibrium allocation. The intuition for that result is straight-
forward: with the subsidy in place, there is only one e¤ective distortion left in
the economy, namely, sticky prices. By stabilizing markups at their “friction-
less”level, nominal rigidities cease to be binding, since …rms do not feel any
desire to adjust prices. By construction, the resulting equilibrium allocation
is e¢ cient, and the price level remains constant.
In an open economy–and as noted, among others, by Corsetti and Pe-
senti (2001)–there is an additional factor that distorts the incentives of the
monetary authority, beyond the presence of market power: the possibility
of in‡uencing the terms of trade in a way bene…cial to domestic consumers.
This possibility is a consequence of the imperfect substitutability between
domestic and foreign goods, combined with sticky prices (which render mon-
etary policy non-neutral). As shown below, and as discussed by Benigno and
Benigno (2003) in the context of a two-country model, the introduction of an
employment subsidy that exactly o¤sets the market power distortion is not
su¢ cient to render the ‡exible price equilibrium allocation optimal, for, at
the margin, the monetary authority would have an incentive to deviate from
it to improve the terms of trade.

23
 For the special parameter con…guration = = = 1 we can derive an-
alytically the employment subsidy that exactly o¤sets the combined e¤ects
of market power and the terms of trade distortions, thus rendering the ‡ex-
ible price equilibrium allocation optimal. That result, in turn, rules out the
existence of an average in‡ation (or de‡ation) bias, and allows us to focus
on policies consistent with zero average in‡ation, in a way analogous to the
analysis for the closed economy found in chapter 4. Perhaps not surprisingly,
and as we show below, the policy that maximizes welfare in that case re-
quires that domestic in‡ation be fully stabilized, while allowing the nominal
exchange rate (and, as a result, CPI in‡ation) to adjust as needed in order to
replicate the response of the terms of trade that would obtain under ‡exible
prices.
One may wonder to what extent the optimality of strict domestic in‡ation
targeting is speci…c to the special case considered here or whether it carries
over to a more general case. The optimal policy analysis undertaken in Faia
and Monacelli (2007) using a model nearly identical to the one considered
here suggests that while the optimal policy involves some variation in the do-
mestic price level, the latter is almost negligible from a quantitatively point
of view, thus making strict domestic in‡ation targeting a good approxima-
tion to the optimal policy (at least conditional on the productivity shocks
considered here). Using a di¤erent approach, De Paoli (2006) reaches a simi-
lar conclusion, except when an (implausibly) high elasticity of substitution is
assumed.12 But even in the latter case the losses that arise from following a
domestic in‡ation targeting policy are negligible.13 More generally, it is clear
that there are several channels in the open economy that may potentially
render a strict domestic in‡ation policy suboptimal, including non-unitary
elasticity of substitution, local currency pricing, incomplete …nancial mar-
kets, etc. , all of which are unrelated to the sources of policy tradeo¤s that
may potentially arise in the closed economy. The quantitative signi…cance of
12
Those results are conditional on productivity shocks being the driving force. Not sur-
prisingly, in the presence of cost-push shocks of the kind considered in chapter 5 stabilizing
domestic in‡ation is not optimal (as in the closed economy).
13
In solving the optimal policy problem for the general case, de Paoli (2006) adopts
the linear-quadratic approach originally developed in Benigno and Woodford (2005), and
which replaces the linear terms in the approximation to the households’ welfare losses
using a second order approximation to the equilibrium conditions.. Faia and Monacelli
(2007) solve for the Ramsey policy using the original nonlinear equilibrium conditions as
contraints of the policy problem.

24
the e¤ects of those channels (individually or jointly) still needs to be explored
in the literature, and its analysis is clearly beyond the scope of the present
chapter.
With that consideration in mind, we next turn to the analysis of the
optimal policy in the special case mentioned above.

4.0.2 The E¢ cient Allocation and its Decentralization

Let us …rst characterize the optimal allocation from the viewpoint of a so-
cial planner facing the same resource constraints to which the small open
economy is subject in equilibrium (vis a vis the rest of the world), given our
assumption of complete markets. In that case, the optimal allocation must
maximize U (Ct ; Nt ) subject to (i) the technological constraint Yt = At Nt ,
(ii) a consumption/output possibilities set implicit in the international risk
sharing conditions (18), and (iii) the market clearing condition (25).
Consider the special case of = = = 1. In that case, (19) and (26)
imply the exact expression Ct = Yt1 (Yt ) . The optimal allocation (from
the viewpoint of the small open economy, which takes world output as given)
must satisfy,
Un (Ct ; Nt ) Ct
= (1 )
Uc (Ct ; Nt ) Nt
which, under our assumed preferences and given = 1, can be written as
Ct
Ct Nt' = (1 )
Nt
1
thus implying a constant employment N = (1 ) 1+' .
Notice, on the other hand, that the ‡exible price equilibrium in the small
open economy (with corresponding variables denoted with an n superscript)
satis…es:

1
1 = M Ctn
n
(1 ) Un;t
= (Stn ) n
At Uc;t
(1 ) Ytn
= (Ntn )' Ctn
At Ctn
= (1 ) (Ntn )1+'

25
where the term on the right hand side of the second equality corresponds to
the real wage (net of the subsidy) normalized by productivity, and where the
third equality follows from (26).
Hence, by setting such that (1 )(1 ) = 1 1 is satis…ed (or, equiv-
alently, = + log(1 )) we guarantee the optimality of the ‡exible price
equilibrium allocation. As in the closed economy case, the optimal monetary
policy requires stabilizing the output gap (i.e., yet = 0, for all t). Equation
(37) then implies that domestic prices are also stabilized under that optimal
policy ( H;t = 0 for all t). Thus, in the special case under consideration,
(strict) domestic in‡ation targeting (DIT) is indeed the optimal policy.

4.1 Implementation and Macroeconomic Implications

In this section we discuss the implementation a domestic in‡ation targeting
policy (DIT) and characterize some of its equilibrium implications. While
that policy has been shown to be optimal only for the special case considered
above, we look at the implications of that policy for the general case.

4.1.1 Implementation
As discussed above full stabilization of domestic prices implies

yet = H;t =0
for all t. This in turn implies that yt = ytn and it = rtn will hold in equilibrium
for all t, with all the remaining variables matching their natural levels at all
times.
For the reasons discussed in chapter 4, an interest rate rule of the form
it = rtn is associated with an indeterminate equilibrium, and hence does not
guarantee that the outcome of full price stability be attained. That result
follows from the equivalence between the dynamical system describing the
equilibrium of the small open economy and that of the closed economy of
chapter 4. As shown there, the indeterminacy problem can be avoided, and
the uniqueness of the price stability outcome restored, by having the cen-
tral bank follow a rule which makes the interest rate respond with su¢ cient
strength to deviations of domestic in‡ation and/or the output gap from tar-
get. More precisely, we can guarantee that the desired outcome is attained
if the central bank commits itself to a rule of the form

26
 it = rtn + H;t + y yet (43)
where ( 1) + (1 ) y > 0. Note that, in equilibrium, the term
H;t + e
y
y t will vanish (since we will have yet = H;t = 0), implying that
n
it = rt all t.

4.1.2 Macroeconomic Implications

Under strict domestic in‡ation targeting (DIT), the behavior of real variables
in the small open economy corresponds to the one we would observe in the
absence of nominal rigidities. Hence, we see from inspection of equation (36)
that domestic output always increases in response to a positive technology
shock at home. As discussed earlier, the sign of the response to a rise in
world output is ambiguous, however, and it depends on the sign of , which
in turn depends on the size of the substitutability parameters and and
the risk aversion parameter .
The natural level of the terms of trade is given by:

snt = (ytn yt )
= ( 0 + a at yt )
+'
where +'
> 0. Thus, given world output, an improvement in domes-
tic technology always leads to a real depreciation, through its expansionary
e¤ect on domestic output. On the other hand, an increase in world output
always generates an improvement in the domestic terms of trade (i.e., a real
appreciation), given domestic technology.
Given that domestic prices are fully stabilized under DIT, it follows that
DIT
et = snt pt , i.e., the nominal exchange rate moves one-for-one with the
(natural) terms of trade and (inversely) with the world price level. Assuming
constant world prices, the nominal exchange rate will inherit all the statistical
properties of the natural terms of trade. Accordingly, the volatility of the
nominal exchange rate under DIT will be proportional to the volatility of
the gap between the natural level of domestic output (in turn related to
productivity) and world output. In particular, that volatility will tend to
be low when domestic natural output displays a strong positive comovement
with world output. When that comovement is low (or negative), possibly
because of a large idiosyncratic component in domestic productivity, the

27
volatility of the terms of trade and the nominal exchange rate under DIT
will be enhanced.
We can also derive the implied equilibrium process for the CPI. Given
the constancy of domestic prices it is given by:

pDIT
t = (eDIT
t + pt )
n
= st

Thus, we see that under the DIT regime, the CPI level will also vary with
the (natural) terms of trade and will inherit its statistical properties. If the
economy is very open, and if domestic productivity (and hence the natural
level of domestic output) is not much synchronized with world output, CPI
prices could potentially be highly volatile, even if the domestic price level is
constant.
An important lesson emerges from the previous analysis: potentially large
and persistent ‡uctuations in the nominal exchange rate as well as in some
in‡ation measures (like the CPI) are not necessarily undesirable, nor do they
require a policy response aimed at dampening such ‡uctuations. Instead, and
especially for an economy that is very open and subject to large idiosyncratic
shocks, those ‡uctuations may be an equilibrium consequence of the adoption
of an optimal policy, as illustrated by the model above.

4.2 The Welfare Costs of Deviations from the Optimal

Policy
Under the particular assumptions for which strict domestic in‡ation tar-
geting has been shown to be optimal (i.e., log utility and unit elasticity of
substitution between goods of di¤erent origin), it is relatively straightforward
to derive a second order approximation to the utility losses of the domestic
representative consumer resulting from deviations from the optimal policy.
Those losses, expressed as a fraction of steady state consumption, can be
written as:

(1 )X
1 h i
t 2
W= H;t + (1 + ') yet2 (44)
2 t=0

The derivation of (44) goes along the lines of that for the closed economy

28
shown the appendix of chapter 4. The reader is referred to Galí and Monacelli
(2005) for the details speci…c to (44).
The expected period welfare losses of any policy that deviates from strict
in‡ation targeting can be written in terms of the variances of in‡ation and
the output gap:

(1 ) h i
V= var( H;t ) + (1 + ') var(e
yt ) (45)
2
Note that the previous expressions for the welfare losses are, up to the
proportionality constant (1 ), identical to the ones derived for the closed
economy in chapter 4, with domestic in‡ation (and not CPI in‡ation) being
the relevant in‡ation variable. Below we make use of (45) to assess the
welfare implications of alternative monetary policy rules, and to rank those
rules on welfare grounds.

5 Simple Monetary Policy Rules for the Small

Open Economy
In the present section we analyze the macroeconomic implications of three
alternative monetary policy regimes for the small open economy. Two of
the simple rules considered are stylized Taylor-type rules. The …rst has the
domestic interest rate respond systematically to domestic in‡ation, whereas
the second assumes that CPI in‡ation is the variable the domestic central
bank reacts to. The third rule we consider is one that pegs the e¤ective
nominal exchange rate. Formally, the domestic in‡ation-based Taylor rule
(DITR, for short) is speci…ed as follows:

it = + H;t

The CPI in‡ation-based Taylor rule (CITR, for short) is assumed to take
the form:

it = + t

Finally, the exchange rate peg (PEG, for short) implies

et = 0

for all t.

29
 Below we provide a comparison of the equilibrium properties of several
macroeconomic variables under the above simple rules for a calibrated version
of our model economy. We compare such properties to those associated with
a strict domestic in‡ation targeting (DIT), the policy that is optimal under
the conditions discussed above, and which we assume to be satis…ed in our
baseline calibration. As much of the present chapter the analysis draws
directly from Galí and Monacelli (2005).

5.1 A Numerical Analysis of Alternative Rules

5.1.1 Calibration
In this section we present some quantitative results based on a calibrated
version of our small open economy. In our baseline calibration we set =
= = 1, in a way consistent with the special case considered above. We
assume ' = 3, which implies a labor supply elasticity of 31 . We set , the
elasticity of substitution between di¤erentiated goods (of the same origin) to
be equal to 6, thus implying a steady-state markup of 20 percent. Parameter
is set equal to 0:75, a value consistent with an average period of one year
between price adjustments. We assume = 0:99, which implies a riskless
annual return of about 4 percent in the steady state. We set a baseline value
for (the degree of openness) of 0:4. The latter corresponds roughly to
the import/GDP ratio in Canada, which we take as a prototype small open
economy. In the calibration of the interest rate rules we follow the original
Taylor calibration and set equal to 1:5.
In order to calibrate the stochastic properties of the exogenous driving
forces, we …t AR(1) processes to (log) labor productivity in Canada (our
proxy for domestic productivity), and (log) U.S. GDP (taken as a proxy
for world output), using quarterly, HP-…ltered data over the sample period
1963:1 2002:4. We obtain the following estimates (with standard errors in
brackets):

at = 0:66 at 1 + "at , a = 0:0071

(0:06)
yt = 0:86 yt 1 + "t , y = 0:0078
(0:04)

with corr("at ; "t ) = 0:3.

30
5.1.2 Impulse Responses
We start by describing the dynamic e¤ects of a domestic productivity shock
on a number of macroeconomic variables. Figure 1 displays the impulse
responses to a unit innovation in at under the four regimes considered. By
construction, domestic in‡ation and the output gap remain unchanged under
the optimal policy (DIT). We also see that the shock leads to a persistent
reduction in the domestic interest rate, as it is needed in order to support
the transitory expansion in consumption and output consistent with the ‡ex-
ible price equilibrium allocation. Given the constancy of the world nominal
interest rate, uncovered interest parity implies an initial nominal depreci-
ation followed by expectations of a future appreciation, as re‡ected in the
response of the nominal exchange rate. Given constant world prices and the
stationarity of the terms of trade, the constancy of domestic prices implies a
mean-reverting response of the nominal exchange rate.
It is interesting to contrast the implied dynamic behavior of the same
variables under the optimal policy to the one under the two stylized Taylor
rules (DITR and CITR). Notice, at …rst, that both rules generate, unlike the
optimal policy, a permanent fall in both domestic and CPI prices. The unit
root in domestic prices is then mirrored, under both rules, by the unit root
in the nominal exchange rate.
A key di¤erence between the two Taylor rules concerns the behavior of the
terms of trade. While under DITR there is a real depreciation on impact,
with the terms of trade reverting gradually to the steady state after that
(mirroring closely the response under the optimal policy), under CITR the
initial response of the terms of trade is more muted, and is followed by a
hump-shaped pattern. The intuition is simple. Under both rules, the rise
in domestic productivity and the required real depreciation lead, for given
domestic prices, to an increase in CPI in‡ation. However, under CITR the
desired stabilization of CPI in‡ation is partly achieved, relative to DITR,
by means of a more muted response of the terms of trade (since the latter
a¤ect the CPI), and a fall in domestic prices. The latter, in turn, requires a
negative output gap and hence a more contractionary monetary policy (i.e.,
a higher interest rate). Under our calibration that policy response takes the
form of an initial rise in both the nominal and real interest rates, with the
subsequent path of the real rate remaining systematically above that implied
by the optimal policy or a DITR policy.
Finally, the same …gure displays the corresponding impulse responses un-

31
der the PEG policy. Notice that the responses of output gap and in‡ation
are qualitatively similar to the CITR case. However, the impossibility of
lowering the nominal rate and letting the currency depreciate, as would be
needed in order to support the expansion in consumption and output required
to replicate the ‡exible price allocation, leads to a very limited response in
the terms of trade, and in turn an ampli…cation of the negative response of
domestic in‡ation and the output gap. Interestingly, under a PEG, the com-
plete stabilization of the nominal exchange rate generates stationarity of the
domestic price level and, in turn, also of the CPI level (given the stationarity
in the terms of trade). This is a property that the PEG regime shares with
the optimal policy as speci…ed above. The stationarity in the price level also
explains why, in response to the shock, domestic in‡ation initially falls and
then rises persistently above the steady state.
As discussed below the di¤erent dynamics of the terms of trade are un-
ambiguously associated with a welfare loss, relative to the optimal policy.

5.1.3 Second Moments and Welfare Losses

In order to complement our quantitative analysis, Table 1 reports business
cycle properties of several key variables under alternative monetary policy
regimes. The numbers con…rm some of the …ndings that were already evident
from visual inspection of the impulse responses. Thus we see that the critical
element that distinguishes each simple rule relative to the optimal policy is
the excess smoothness of both the terms of trade and the (…rst-di¤erenced)
nominal exchange rate.14 This in turn is re‡ected in too high a volatility of
the output gap and domestic in‡ation under the simple rules. In particular,
the PEG regime is the one that ampli…es both output gap and in‡ation
volatility to the largest extent, with the CITR regime lying somewhere in
between. Furthermore, notice that the terms of trade are more stable under
an exchange rate peg than under any other policy regime. That …nding,
which is consistent with the evidence of Mussa (1986), points to the existence
of “excess smoothness” in real exchange rates under …xed exchange rates.
That feature is a consequence of the inability of prices (which are sticky) to
compensate for the constancy of the nominal exchange rate.15
Table 2 reports the welfare losses associated with the three simple rules
14
We report statistics for the nominal depreciation rate, as opposed to the level, given
that both DITR and CITR imply a unit root in the nominal exchange rate.
15
See Monacelli (2004) for a detailed analysis of the implications of …xed exchange rates.

32
analyzed in the previous section: DITR, CITR and PEG. There are four
panels in this table. The top panel reports welfare losses in the case of our
benchmark parameterization, while the remaining three panels display the
e¤ects of lowering the steady-state markup (as implied by an increase in ),
the elasticity of labor supply, and both. All entries are to be read as per-
centage units of steady state consumption, and in deviation from the …rst
best represented by DIT. Under our baseline calibration all rules are subopti-
mal since they involve nontrivial deviations from full domestic price stability.
Also one result stands out clearly: under all the calibrations considered an
exchange rate peg implies a substantially larger deviation from the …rst best
than DITR and CITR, as one may have anticipated from the quantitative
evaluation of the second moments conducted above. However, and as is
usually the case in welfare exercises of this sort found in the literature, the
implied welfare losses are quantitatively small for all policy regimes.
We consider next the e¤ect of lowering, respectively, the steady-state
markup to 1:1, by setting = 11 (which implies a larger penalization of
in‡ation variability in the loss function) and the elasticity of labor supply to
0:1 (which implies a larger penalization of output gap variability). This has
a general e¤ect of generating a substantial magni…cation of the welfare losses
relative to the benchmark case, especially in the third exercise where both
parameters are lowered simultaneously. In the case of low markup and low
elasticity of labor supply, the PEG regime leads to non trivial welfare losses
relative to the optimum. Notice also that under all scenarios considered here
the two stylized Taylor rules, DITR and CITR, imply very similar welfare
losses. While this points to a substantial irrelevance in the speci…cation of
the in‡ation index in the monetary authority’s interest rate rule, the same
result may once again be sensitive to the assumption of complete exchange
rate pass-through speci…ed in our context.

6 Notes on the Literature

Earlier work on optimizing open economy models with nominal rigidities
focused on the transmission of monetary policy shocks, typically represented
as disturbances to an exogenous stochastic process for the money supply.16
A key contribution in that area is Obstfeld and Rogo¤ (1995), who develop a
two country model where monopolistically competitive …rms set prices before
16
See Lane (1999) for an excellent survey of the early steps in that literature.

33
the realization of the shocks (i.e. one period in advance). The framework
is used to analyze the dynamics of the exchange rate and other variables
in response to a change in the money supply (and government spending),
and the welfare e¤ects resulting from that intervention. An earlier paper, by
Svensson and van Wijnbergen (1989) contains a related analysis, under the
assumption of full risk-sharing among consumers from di¤erent countries.
Corsetti and Pesenti (2001) develop a version of the Obstfeld-Rogo¤
model that allows for home-bias in preferences, leading to terms of trade
e¤ects in response to shocks that are argued to have potentially important
welfare e¤ects. Betts and Devereux (2000) revisit the analysis in Obstfeld
and Rogo¤ (1995) while departing from the assumption of the law of one
price found in the latter paper. In particular they allow …rms to price dis-
criminate across markets and assuming they set prices (in advance) in terms
of the currency of the importing country ("pricing to market").
The e¤ects of money supply shocks on the persistence and volatility of
nominal and real exchange rates are analyzed under the assumption of stag-
gered price-setting in Kollmann (2001) and Chari, Kehoe and McGrattan
(2002).17 The assumption of staggered price setting (and staggered wage
setting in Kollmann’s case) induces much richer and more realistic dynamics
than that of price setting one period in advance.
A more recent strand of the literature has attempted to go beyond the
analysis of the transmission of exogenous monetary policy shocks, and has
focused instead on the implications of sticky price open economy models for
the design of optimal monetary policy, using a welfare theoretic approach.18
Early examples of papers analyzing the properties of alternative monetary
policy arrangements in a two-country setting assumed that prices are set
one period in advance, They include the work of Obstfeld and Rogo¤ (2002)
and Benigno and Benigno (2003), both using the assumption of producer
currency pricing, and Bacchetta and van Wincoop (2001), Sutherland (2002),
Devereux and Engel (2003), and Corsetti and Pesenti (2005) in the context
of economies with local currency pricing.
More recent frameworks have instead adopted the staggered price-setting
structure à la Calvo. Galí and Monacelli (2005), on which the analysis of
17
Kollmann (2001) assumes prices and wages are set à la Calvo–as in the model of the
present chapter–whereas Chari et al. (2002) assume price setting à la Taylor, i.e. with
deterministic price durations.
18
Ball (1999) and Svensson (2000) carry out an analysis similar in spirit, but in the
context of non-optimizing models.

34
the present chapter is based, is an illustration of work along those lines for
a small open economy. An extension of that framework incorporating cost-
push shocks can be found in Clarida, Galí and Gertler (2001). Kollmann
(2002) considers a more general model of a small open economy, with several
sources of shocks, and carries out a numerical analysis of the welfare impli-
cations of alternative rules. Using a similar framework as a staring point,
Monacelli (2005) shows that the introduction of imperfect pass-through gen-
erates a trade-o¤ between stabilization of domestic in‡ation and the output
gap, leading to gains from commitment similar to those analyzed in chapter
5 for the closed economy.
Finally, the papers by Clarida, Galí and Gertler (2002), Pappa (2004),
and Benigno and Benigno (2006) depart from the assumption of a small
open economy and analyze the consequences of alternative monetary policy
arrangement in a two-country framework with staggered price setting à la
Calvo, and with a special focus on the gains from cooperation.

35
 Appendix. The Perfect Foresight Steady State
In order to show how the home economy’s terms of trade are uniquely
pinned down in the perfect foresight steady state, we invoke symmetry among
all countries (other than the home country), and then show how the terms
of trade and output in the home economy are determined. Without loss of
generality, we assume a unit value for productivity in all foreign countries,
and a productivity level A in the home economy. We show that in the
symmetric case (when A = 1) the terms of trade for the home economy must
necessarily be equal to unity in the steady state, whereas output in the home
economy coincides with that in the rest of the world.
First, notice that the goods market clearing condition, when evaluated at
the steady state, implies:

Z 1
PH PH PFi
Y = (1 ) C+ C i di
P 0 Ei PFi Pi
" Z #
1
PH Ei PFi
= (1 )C+ Qi C i di
P 0 PH
Z 1 1
= h(S) C (1 )+ S i Si Qi di
0
h 1
i
= h(S) C (1 )+ S q(S)

where we have made use of (18) and of the relationship

Z 1
1
P 1
1

= (1 )+ (Si ) di
PH 0
1
= (1 )+ (S)1 1
h(S)
S
and we have substituted Q = h(S) q(S). Notice that q(S) is strictly
increasing in S.
Under the assumptions above, the international risk sharing condition
implies that the relationship

1
C = C Q
1
= C q(S)

36
must also hold in the steady state.
Hence, combining the two relations above, and imposing the world market
clearing condition C = Y we obtain
h 1
i
Y = (1 ) h(S) q(S) + S h(S) q(S) Y
h 1
i
= (1 ) h(S) q(S) + h(S) q(S) Y
v(S) Y (46)

where v(S) > 0, v 0 (S) > 0, and v(1) = 1.

Furthermore, the clearing of the labor market in steady state implies
'
Y W
C =
A P
1
1 PH
= A
(1 ) P
1
1 1
= A
(1 ) h(S)

which, when combined with the sharing condition above, yields

1
1+' 1 1 '

Y =A ' (47)
(1 ) (Y ) S

Notice that, conditional on A and Y , (46) and (47) constitute a system

of two equations in Y and S, with a unique solution, given by
1
1
1+' 1 +'

Y =Y =A +'
1

and
S=1
which in turn must imply Si = 1 for all i.

37
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38
 Faia, Ester and Tommaso Monacelli (2007): "Optimal Monetary Policy
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39
 Exercises
1. A Small Open Economy Model
Consider a small open economy where no international trade in assets is
allowed (implying that trade is always balanced). Hence,

pt + ct = pH;t + yt

where ct denotes consumption, yt is output, pH;t is the domestic price level,

pt is the CPI (all in logs). Assuming a constant price level in the rest of the
world (pt = 0), we can write

pt = (1 ) pH;t + et

where et is the nominal exchange rate.

Let st et pH;t denote the terms of trade. Under the assumption of a
unit elasticity of substitution between foreign and domestic goods we have

st = y t yt

where yt is (log) output in the rest of the world (assumed to evolve exoge-
nously). The domestic aggregate technology can be written as

y t = at + n t

where at is an exogenous technology process. We assume perfect competition

in both goods and labor markets, with ‡exible prices and wages. The labor
supply takes the form:
wt pt = ct + ' nt
Finally, we assume a money demand function mt pt = ct
a) Determine the equilibrium processes for output, consumption, the
terms of trade, and the nominal exchange rate in the small open economy, as
a function of productivity at , foreign output yt , and the money supply under
the assumption that the latter evolves exogenously. Discuss the implications
of assuming = 1.
b) How would your answer have to be modi…ed if a …xed nominal exchange
rate regime was in place?
c) Discuss, in words, how some of the results in a) and b) would change
qualitatively in the presence of imperfect competition and sticky prices.

40
 2. The E¤ects of Technology Shocks in the Open Economy
Consider the small open economy model described in the present chapter.
The equilibrium dynamics for domestic in‡ation H;t and the output gap yet
are described by the equations:

H;t = Et f H;t+1 g + yet

1
yet = Et fe
yt+1 g (it Et f H;t+1 g rtn )

and where rtn is given by

rtn = b at
Natural output is in turn given by

ytn = d at

The technology parameter folloxs a stationary AR(1) process

at = a at 1 + "at

where a 2 [0; 1).

Assume that the monetary authority follows the simple interest rate rule

it = + H;t

where > 1.
a) Determine the response of output, domestic in‡ation, the terms of
trade and the nominal exchange rate to a positive domestic technology shock
(note: for the purposes of the present exercise we assume yt = pt = 0 all t)
b) Suppose that the central bank pegs the nominal exchange rate, so that
et = 0 for all t. Characterize the economy’s response to a technology shock
in that case.

41