Optimal Monetary Policy in a Small Open Economy: A General Equilibrium Analysis

This paper uses a small open economy model to address two outstanding issues in monetary policy: (1) what restrictions on the policy rule ensure that the central bank does not introduce real indeterminacy into the economy, and (2) what is the optimal long run rate of inflation. The small open economy model provides unique insights on both fronts. In the case of determinacy issues, the model’s simplicity makes the analysis remarkably transparent. As for long run inflation rates, a small open economy takes as given the foreign nominal interest rate. To the extent that this rate distorts domestic behavior, there is a role for positive domestic nominal rates (in contrast to Friedman’s celebrated optimum quantity of money). This motivation arises naturally in the setting of a small open economy. *This paper was prepared for Third Annual Conference of the Central Bank of Chile, “Monetary Policy: Rules and Transmission Mechanisms,” held in Santiago, September 20-21, 1999.