Monetary Policy in a Small Open Economy with Imperfect Pass-Through

Abstract

This paper studies the stabilization and welfare properties of various monetary policy regimes in a tractable framework suitable for the analysis of monetary policy in a small open economy environment with imperfect pass-through and inflation indexation. Using welfare criteria to evaluate the best monetary policy, results show that price-level targeting performs well and provides an alternative method for conducting successful monetary policy in the case of a small-open economy. Benefits of price-level targeting rules noted in the literature for closed economies also translate to the small open economy setting once allowing for the combination of inflation inertia and exchange rate imperfect pass-through. As the exchange rate is an important element of the transmission of monetary policy, movements in these variable and other foreign variables often account for a significant part of the variation in the consumer price index via their direct effect on the price of imported goods. Imperfect exchange rate pass-through favors the choice of price-level targeting over consumer price index inflation targeting.

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Notes

  1. 1.

    Campa and Goldberg (2005) rejected the hypothesis of complete pass-through in 22 of 25 countries during the 1975–99 sample period.

  2. 2.

    In their analysis of price-level versus inflation targeting, Batini and Yates (2003) demonstrated that output and inflation volatility may be dramatically worse under a price-level objective than under an inflation objective if expectations are formed in a backward-looking manner.

  3. 3.

    See Rabanal and Rubio-Ramírez (2005), for a general discussion about price indexation.

  4. 4.

    Erceg et al. (2000) used indexation to the steady-state inflation rate, allowing them to compute a linearized equation for inflation combining expected future inflation and lagged inflation. Their equation differs from the forward-looking inflation process obtained under the standard Calvo model.

  5. 5.

    The forward-looking pricing decision is related to the fact that firms that adjust their price in any period do so for a random number of periods. The price is then set as a markup over the average of expected future marginal costs.

  6. 6.

    Setting \( {\gamma}_p^{\ast } \) so that it is equal to the domestic price-indexation coefficient (or \( {\gamma}_p^{\ast}\ne 0 \)) does not significantly change the policy-evaluation results.

  7. 7.

    In our model, three definitions of output have to be handled: a measure of output, natural output (which can be derived in an economy with no imperfection or nominal rigidity) and finally the output gap, which is the difference between the output and the natural output.

  8. 8.

    Leith and Malley (2007) estimated an open-economy NKPC for the G7 countries, using a model with backward-looking behavior. They found that this parameter ranged from 0.54 in some countries to up to as high as 0.87 in others.

  9. 9.

    In the original Taylor rule, the weights on the output gap and inflation were set to the standard weight of 0.5, which is common in the literature.

  10. 10.

    The application of the quadratic approximation of the objective function is complex and cannot be simply derived in an open-economy model with sticky prices. A popular measure thus uses inflation and output gap volatility, in addition to the utility function.

  11. 11.

    Kollmann (2002), Smets and Wouters (2003) and Rubio and Carrasco-Gallego (2014) are examples of papers in which monetary-policy welfare implications are investigated.

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Correspondence to Mohamed Douch.

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Douch, M. Monetary Policy in a Small Open Economy with Imperfect Pass-Through. Atl Econ J 47, 445–461 (2019). https://doi.org/10.1007/s11293-019-09646-1

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Keywords

  • Small-open economy
  • Monetary policy
  • Inflation targeting
  • Price level targeting
  • Exchange rate imperfect pass-through

JEL

  • E31
  • E52
  • E58