Monetary Policy and Exchange Rate Volatility in a Small Open Economy

Does inflation reduce welfare? What is worse, a volatile exchange rate or a high inflation rate? And is the central bank able to drive these variables?These questions are the topic of a paper by Jordi Gali and Tommaso Monacelli, published in 2005 and titled "Monetary Policy and Exchange Rate Volatility in a Small Open Economy." As apparent by the title Gali and Monacelli (G+M) analyze the influence of monetary policy on the volatility of the exchange rate, more precisely the nominal exchange rate and the terms oftrade. For this purpose they create a small open economy with sticky prices of Calvo-type. Due to its minor size this economy does not influence the world economy. However, depending onthe degree of openness this economy is affected by the rest of the world.Having specified this framework, G+M introduce three different monetary regimes and evaluate the resulting exchange rate volatilities . Using a central bank loss function G+M rank these three rules according to the implied welfare which shows a positive correlation between welfare and exchange rate volatility. Thence G+M prefer Taylor rules over an exchange rate pegging.To get a general idea of Gali and Monacellis argumentation this expose will start in chapter 2 with an abbreviated overlook over G+M's model of a small open economy. In the following chapter there will be the introduction of the three central bank rules, necessary to close the model, as well as an analysis of the underlying welfare levels. Since the welfare evaluation isbased on some special assumptions, chapter 4 will give an overview of recent literature which discusses possible extensions as well as their implications for G+M's ranking of implied welfare. Concluding chapter 5 will summarize G+M's most important results as well as evaluate if the possible extensions render G+M's analysis, respectively their results, worthless.