Liquidity trap and optimal monetary policy in open economies

Review of Economic Studies, 2005

We lay out a small open economy version of the Calvo sticky price model, and show how the equilibrium dynamics can be reduced to simple representation in domestic inflation and the output gap. We use the resulting framework to analyze the macroeconomic implications of three alternative rule-based policy regimes for the small open economy: domestic inflation and CPI-based Taylor rules, and an exchange rate peg. We show that a key difference among these regimes lies in the relative amount of exchange rate volatility that they entail. We also discuss a special case for which domestic inflation targeting constitutes the optimal policy, and where a simple second order approximation to the utility of the representative consumer can be derived and used to evaluate the welfare losses associated with the suboptimal rules.

Weltwirtschaftliches Archiv, 1982

2002

Using an optimizing model we derive the optimal monetary and exchange rate policy for a small stochastic open economy with imperfect competition and short run price rigidity. The optimal monetary policy has an exact closed-form solution and is obtained using the utility function of the representative home agent as welfare criterion. The optimal policy depends on the source of stochastic disturbances affecting the economy, much as in the literature pioneered by . Optimal monetary policy reacts to domestic and foreign disturbances. If the intertemporal elasticity of substitution in consumption is less than one, as is likely to be the case empirically, the optimal exchange rate policy implies a dirty float: interest rate shocks from abroad are met partially by adjusting home interest rates, and partially by allowing the exchange rate to move. This optimal pattern may help rationalize the observed fear of floating.

Oxford Economic Papers, 2004

This paper analyses the implications of cost-push shocks for the optimal choice of monetary policy target in a two-country sticky-price model. In addition to cost-push shocks, each country is subject to labour-supply and money-demand shocks. It is shown that the fully optimal coordinated policy can be supported by independent national monetary authorities following a policy of flexible inflation targeting. A number of simple (but non-optimal) targeting rules are compared. Strict producer-price targeting is found to be the best simple rule when the variance of cost-push shocks is small. Strict consumer-price targeting is best for intermediate levels of the variance of costpush shocks. And nominal-income targeting is best when the variance of costpush shocks is high. In general, money-supply targeting and fixed nominal exchange rates are found to yield less welfare than these other regimes.

Journal of Monetary Economics, 2002

We study the international monetary policy design problem within an optimizing two-country sticky price model, where each country faces a short run tradeoff between output and inflation. The model is sufficiently tractable to solve analytically. We find that in the Nash equilibrium, the policy problem for each central bank is isomorphic to the one it would face if it were a closed economy. Gains from cooperation arise, however, that stem from the impact of foreign economic activity on the domestic marginal cost of production. While under Nash central banks need only adjust the interest rate in response to domestic inflation, under cooperation they should respond to foreign inflation as well. In either scenario, flexible exchange rates are desirable.

Economic Theory, 2006

We consider a sticky-price model with segmented asset markets, and examine its implications for monetary policy. Our finding is, first, that the response of the money supply growth rate to a money demand shock required to stabilize inflation is not affected by the existence of a liquidity effect, but the response of the nominal interest rate is. Second, when the monetary authority adopts a Taylor rule, whether or not it should be active to obtain local determinacy of equilibria depends on the existence of a liquidity effect. Our results suggest that the monetary authority should be careful about the existence and the degree of a liquidity effect particularly when the nominal interest rate is used as the policy instrument.

Journal of Monetary Economics

We derive policy implications for an inflation targeting central bank, who's credibility is endogenous and depends on its past ability to achieve its targets. We do this in a New Keynesian framework with heterogeneous agents and boundedly rational expectations. Our assumptions about expectation formations are more in line with expectations observed in survey data and laboratory experiments than the fairly restrictive rational expectations hypothesis. We find that the region of allowed policy parameters is strictly larger under heterogeneous expectations than under rational expectations. Furthermore, with theoretically optimal monetary policy, global stability of the fundamental steady state can be achieved, implying that the system always converges to the targets of the central bank. This result however no longer holds when the zero lower bound (ZLB) on the nominal interest rate is accounted for. Self-fulfilling deflationary spirals can then occur, even under optimal policy. The occurrence of these liquidity traps crucially depends on the credibility of the central bank. Deflationary spirals can be prevented with a high inflation target, aggressive monetary easing, or a more aggressive response to inflation.

Journal of Economic Dynamics and Control, 2008

This paper studies optimal monetary policy with the nominal interest rate as the single policy instrument in an economy, where firms set prices in a staggered way without indexation and real money balances contribute separately to households' utility. The optimal deterministic steady state under commitment is the Friedman rule-even if the importance assigned to the utility of money is small relative to consumption and leisure. We approximate the model around the optimal steady state as the long-run policy target. Optimal monetary policy is characterized by stabilization of the nominal interest rate instead of inflation stabilization as the predominant principle.

This paper examines the properties of interest rate rules aimed at controlling aggregate price inflation. Policies are compared in two models ha"ing either flexible or stic,ky inflation The latter is assumed to derive from a traditional, adaptive-+xpectations augmented Phillips curve. The flexible inflation model derives from the modem view, due to Gray (1976) and Fischr (1977), that market clearing failure in labor markets arises from imperfectly indexed wage contracB with finite durations. E:rtensions positing the existence of overlapping contracts were advancedby Phelps andTaylor( 1977)andCalvo (1983). Themainproblem facing economieswith sticky inflaliep is instability, whereas the principal concem in forward-looking models with flexible inflation ispricelevel andinflationindetemrinacy. Therefore,policiesthat succeedinonekindofeconomy may notwork in another. Nominal ancho$, like money and nominal GNP fail to stabilize prices, unless there is additional intercst rate smoothing. In the flexible inflation regime, interest rate srnoorhing is superfluous, and unique and stable price paths are obtainable with interest rate reaction functions that target nominal GNP, money, and nominal asset prices. In an economy characterized by flexible inflation, a rule for commodity prices proposed by Federal Reserve Board Govemor Wayne D. Angell is shown to be independent of potentially rnknown model pararneters. Although the channels of policy become less dircct, a.s in tbe case of money targeting, an offsetting advantage is derived from the fact that policy is completely determined by observations of readily available spot prices. It is also shown that in a staggereGwage sening model, disinflation is accompanied by increases in output, a conclusion that has questionable plausibility.

Review of Political Economy, Vol. 26, Issue 4, 2014

Monetary policy with an inflation targeting rule is analyzed through a simple small-scale Post-Keynesian model that incorporates open economy issues. In contrast with previous Post-Keynesian attempts, the model embodies policy authorities that are committed not only to hitting inflation and/or output targets, but also to the achievement of the external balance. To take account of the external balance objective, we model the real exchange rate as an endogenous and moving target, with the nominal exchange rate being the instrument of that target. The model shows that in response to an adverse external shock the central bank has to consider first the required real exchange rate adjustment that will preserve the external balance, and secondly the level at which the interest rate must be set in order to maintain inflation stabilization. Keeping inflation to target requires higher interest rates and strong reliance on the unemployment channel which, under certain circumstances, also has adverse side effects on income distribution. We show that to deal with an exogenous external shock a policy mix of real exchange rate targeting and income distribution targeting outperforms inflation targeting.