Chapter 5: Optimal Monetary and Exchange Rate Policy in the Open Economy
The models considered so far have been of closed economies. This has been a convenient simpliﬁcation in considering a number of issues. Real economies are open and international trade and capital ﬂows are important. In this chapter we extend our previous analysis to an open-economy context. New questions raised by openness are also addressed. We consider two types of models diﬀerentiated by degree of capital mobility: perfect versus imperfect. After a brief treatment of the ﬁxed-price model of the type in Chapters 2 and 3, the focus is on open-economy versions of the type of model in Chapter 4, including variable wages and prices, rational expectations and supply shocks. Several patterns emerge. The ﬁrst is the interdependence of the choice of a monetary policy target and the optimal exchange rate regime. The so-called “unholy trinity” of an independent monetary policy, ﬁxed exchange rate and high degree of capital mobility is an example of this interdependence but the connections are ubiquitous. Second, a Poole-type ranking of monetary policies where an interest rate target is preferred when ﬁnancial market shocks are predominant whereas a money supply target is preferred when demand-side shocks to the goods market (IS shocks) are predominant is quite robust to introducing openness to the models. Finally, aggregate supply shocks continue to raise diﬃcult conﬂicts for optimal policy and exchange rate movements are an additional source of supply disturbances. THE MUNDELL–FLEMING MODEL Mundell (1963) and Fleming (1962) developed an open-economy version of the IS...
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