Academic journal article Journal of Money, Credit & Banking

Optimal Monetary Policy in a Small Open Economy with Home Bias

Academic journal article Journal of Money, Credit & Banking

Optimal Monetary Policy in a Small Open Economy with Home Bias

Article excerpt

A CENTRAL ISSUE in the recent open-economy New Keynesian literature is whether exchange rate stabilization should be part of a central bank's monetary policy strategy. This is also the key feature that induces fundamental differences in the design of optimal policy between closed and open economies. (1)

This paper studies optimal monetary policy in a small open economy characterized by home bias in consumption. In our context, the presence of home bias is the key factor generating endogenous real exchange rate fluctuations. Hence, despite the fact that, in the absence of any impediment to trade, the law of one price holds continuously at the level of each individual good, equilibrium deviations from purchasing power parity (PPP) are feasible. In addition, our economy features goods markets characterized by imperfect competition and nominal rigidities, and complete markets for internationally traded state contingent securities.

We refrain from providing a theory of home bias in this context, but rather we model it as a primitive feature of our economic environment. Importantly, the presence of home bias in consumption is a fundamental characteristic of international trade data. For instance, Obstfeld and Rogoff (2003) list home bias in trade as one of the six major puzzles in international macroeconomics. Our interest here is in studying the effects of home bias on the optimal setting of monetary and exchange rate policy.

We study monetary policy both in the case in which firms set prices one period in advance as well as in the case in which prices are set gradually subject to adjustment costs. While the former static setup permits an analytical inspection of the main forces that drive the behavior of the markup under the optimal policy, the latter setup (intrinsically dynamic) emphasizes the impact of future expectations on the optimal policy problem and in particular on the equilibrium volatility of inflation.

Our analysis makes two main contributions. First, we highlight that home bias in consumption is an independent condition inducing the monetary policymaker of an open economy to deviate from an inward-looking strategy of strict markup stabilization, and thus contemplate some (optimal) degree of exchange rate stabilization. This differs from the popular Friedman (1953) prescription, derived for instance in Devereux and Engel (2003), according to which, in the presence of price stickiness, exchange rate movements should be instrumental to have the economy replicate the allocation under purely flexible prices.

In the absence of home bias (i.e., with PPP holding), a motive for deviating from strict markup stabilization generally lies in the possibility of strategically affecting the terms of trade (the relative price of imports). A terms of trade variation, by altering domestic residents' purchasing power, affects consumption for any given level of output (labor effort). In the efficient allocation of an open economy, then, the planner can improve upon the constant-markup allocation prevailing under flexible prices. Previous contributions--such as Corsetti and Pesenti (2001), Sutherland (2002), Benigno and Benigno (2003)--have shown that this terms-of-trade motive for optimal markup variability depends on the underlying specification of the utility function. In particular, it vanishes if either of two conditions holds: (i) the intratemporal elasticity of substitution between domestic and imported goods is unitary, or (ii) that same elasticity coincides with the intertemporal elasticity of substitution in consumption.

This paper suggests that, in the presence of home bias, the conditions for markup stability to be constrained-efficient are more restrictive, in particular, a unitary elasticity of substitution (condition (i) above) ceases to be sufficient for markup stability to be constrained-optimal (whereas sufficiency of condition (ii) still holds). Under home bias, in fact, variations in the terms of trade induce also variations in the real exchange rate (i. …

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