At the heart of the policy debate in international finance lies the question of whether monetary authorities should react to both fluctuations in international relative prices and domestic output and inflation. Several papers have explored how monetary policy should react to disturbances in open economies with complete asset markets. These papers have emphasized that monetary policy is influenced by the presence of a terms of trade externality.
Evidence from the literature suggests that strict domestic inflation targeting would be the optimal monetary policy in producer currency pricing circumstances, except where the trade elasticity of substitution (i.e., the elasticity of substitution between domestic and foreign goods) is implausibly high. In particular, Gali and Monacelli (2005) showed that the optimal monetary policy in a small open economy is isomorphic to the one in the closed economy, when both the intertemporal and intratemporal elasticities of substitution one in the producer currency pricing model.
The recent financial turmoil has generated greater interest in feasible monetary policy prescriptions not only for economies with sophisticated financial structures, but also for economies with fragile financial structures. Although many emerging economies have shifted from a fixed exchange rate to a floating exchange rate regime, the extent to which monetary policy should adjust to account for the impact of the exchange rate on the domestic economy remains highly controversial. Some policymakers in emerging economies still believe in a trade-off between inflation and exchange rate stability, thus bringing into question the desirable form of monetary policy. They believe that monetary policy which preserves the competitiveness of domestic products in the exchange market is necessary to improve the welfare of economies with fragile financial structures.
More recently, Corsetti, Dedola, and Leduc (2010) and De Paoli (2009b) have argued that the configuration of the domestic asset market significantly affects the performance of monetary policy rules, by changing the degree of risk-sharing. In a complete asset market, optimal risk-sharing severs the link between domestic consumption and domestic output, allowing domestic agents to reduce their labor supply without causing a corresponding fall in their consumption levels. In an incomplete asset market, on the other hand, where domestic consumption and domestic output are closely related, domestic households cannot decrease their disutility of labor supply without decreasing their utility from consumption. Therefore, the monetary policy prescription for open economies with complete markets may not hold for open economies with incomplete asset markets.
Contents
1. Introduction
2. The Model
- 2.1 Households
2.2 Asset Markets
2.3 Domestic Firms
2.4 Importing Firms
2.5 Equilibrium
3. Welfare Under Alternative Asset Market Structures
- 3.1 Parameter Values
3.2 Real Exchange Rate and Welfare
3.3 Price Stability vs. Exchange Rate Stability in the Case of Perfect Exchange Rate Pass-Through
3.4 Price Stability versus Exchange Rate Stability in Imperfect Pass-Through
4. Conclusion
References
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Asset Market Structures and Monetary Policy in a Small Open Economy
