This paper considers the appropriate stabilization objectives for monetary policy in a microfounded model with staggered price-setting. Rotemberg and Woodford (1997) and Woodford (2002) have shown that under certain conditions, a local approximation to the expected utility of the representative household in a model of this kind is related inversely to the expected discounted value of a conventional quadratic loss function, in which each period’s loss is a weighted average of squared deviations of inflation and an output gap measure from their optimal values (zero). However, those derivations rely on an assumption of the existence of an output or employment subsidy that offsets the distortion due to the market power of monopolistically-competitive price-setters, so that the steady state under a zero-inflation policy involves an efficient level of output. Here we show how to dispense with this unappealing assumption, so that a valid linear-quadratic approximation to the optimal policy problem is possible even when the steady state is distorted to an arbitrary

We consider a general class of nonlinear optimal policy problems involving forward-looking constraints (such as the Euler equations that are typically present as structural equations in DSGE models), and show that it is possible, under regularity conditions that are straightforward to check, to derive a problem with linear constraints and a quadratic objective that approximates the exact problem. The LQ approximate problem is computationally simple to solve, even in the case of moderately large state spaces and flexibly parameterized disturbance processes, and its solution represents a local linear approximation to the optimal policy for the exact model in the case that stochastic disturbances are small enough. We derive the second-order conditions that must be satisfied in order for the LQ problem to have a solution, and show that these are stronger, in general, than those required for LQ problems without forward-looking constraints. We also show how the same linear approximations to the model structural equations and quadratic approximation to the exact welfare measure can be used to correctly rank alternative simple policy rules, again in the case of small enough shocks.

We analyze optimal monetary policy in a small open economy characterized by home bias in consumption. Peculiar to our framework is the application of a Ramsey-type analysis to a model of the recent open economy New Keynesian literature. We show that home bias in consumption is a su ¢ cient condition for inducing monetary policy-makers of an open economy to deviate from a strategy of strict markup stabilization and contemplate some (optimal) degree of exchange rate stabilization. We focus on the optimal setting of policy both in the case in which …rms set prices one period in advance as well as in the case in which …rms set prices in a dynamic forward-looking fashion. While the …rst setup allows us to analytically highlight home bias as an independent source of equilibrium markup variability, the second setup allows to study the e¤ects of future expectations on the optimal policy problem and the e¤ect of home bias on optimal ination volatility. The latter, in particular, is shown to be related to the degree of trade openness in a U-shaped fashion, whereas exchange rate volatility is monotonically decreasing in openness.

Abstract The short-run effects of fiscal policy depend not only on current tax and spending choices, but also on expectations about future policy adjustment. While general equilibrium models typically restrict medium-term adjustment to taxation, we highlight the importance of government spending dynamics. First, we provide time-series evidence for the U.S. suggesting that an exogenous increase in government spending prompts a rise in public debt, followed over time by a reduction in spending below trend. Second, we show how expected spending reversals alter the short-run impact of fiscal policy in a new Keynesian model, bringing it closer in line with the evidence.

This paper undertakes a Bayesian analysis of optimal monetary policy for the U.K. We estimate a suite of monetary-policy models that include both forwardand backward-looking representations as well as large- and small-scale models. We find an optimal simple Taylor-type rule that accounts for both model and parameter uncertainty. For the most part, backward-looking models are highly fault tolerant with respect to policies optimized for forward-looking representations, while forward-looking models have low fault tolerance with respect to policies optimized for backward-looking representations. In addition, backward-looking models often have lower posterior probabilities than forwardlooking models. Bayesian policies therefore have characteristics suitable for inflation and output stabilization in forward-looking models. 1

International Monetary Fund The resumption of capital flows to emerging-market economies since mid-2009 has posed two sets of interrelated challenges for policymakers: (i) to prevent capital flows from exacerbating overheating pressures and consequent inflation, and (ii) to minimize the risk that prolonged periods of easy financing conditions will undermine financial stability. While conventional monetary policy maintains its role in counteracting the former, there are doubts that it is sufficient to guard against the risks of financial instability. In this context, there have been increased calls for the development of macroprudential measures globally. Against this background, this paper analyzes the interplay between monetary and macroprudential policies in an open-economy DSGE model. The key result is that macroprudential measures can usefully complement monetary policy under a financial shock that triggers capital inflows. Even under the “optimal simple rules, ” introducing macroprudential measures improves welfare. Broad macroprudential measures are shown to be more effective than those that I am grateful to the editor Douglas Gale and an anonymous referee for valuable comments and suggestions. I also thank the participants at the IJCB 4th

Abstract This paper develops and estimates a dynamic stochastic general equilibrium New Keynesian model of a small open economy with partial dollarization. We use Bayesian techniques and Peruvian data to evaluate two forms of dollarization: currency substitution (CS) and price dollarization (PD). Our empirical results are as follows. First, we find that the two forms of partial dollarization are important to explain the Peruvian data. Second, models with both forms of dollarization dominate models without dollarization. Third, a counterfactual exercise shows that by eliminating both forms of partial dollarization the response of both output and consumption to a monetary policy shock doubles, making the interest rate channel of monetary policy more effective. Forth, based on the variance decomposition of the preferred model (with CS and PD), we find that demand type shocks explain almost all the fluctuation in CPI inflation, being the monetary shock the most important (39 percent). Remarkably, foreign disturbances account for 34 percent of output fluctuations.

This paper analyses the international dimension of …scal policy using a small open economy framework in which the government …nances its spending by levying distortionary taxation and issuing non-state-contingent debt. The main …nding of the paper is that, once the open economy aspect of the policy problem is considered, it is not optimal to smooth taxes following idiosyncratic shocks. Even when prices are exible and ination can costlessly act as a shock absorber to restore scal equilibrium, the presence of a terms of trade externality lead to movements in the tax rate. Also in contrast with the closed economy, the introduction of sticky prices, can reduce the optimal volatility of taxes.

This paper aims at analyzing the international dimension of …scal policy. The neoclassical literature on optimal …scal policy has focused mainly on closed economy models suggesting that, when taxes are distortionary, welfare would be maximized if taxes are smoothed over time and across states of nature (see Barro, 1979 and Lucas and Stokey, 1983). In these models, if possible, taxes would be invariant

In contrast to industrialized countries, emerging market economies are characterized by pro-or acyclical monetary policies and high output volatility. This paper argues that those facts can be related to a long-run feature of the economy- namely, its institutional quality (IQL). The paper presents evidence that supports the link between an index of IQL (law and order, government stability, investment profile, etc.), and (i) the cyclicality of monetary policy, and (ii) the volatilities of output and the nominal interest rate. In a DSGE model, foreign investors that choose a portfolio of direct investment and lending to domestic agents, face a probability of partial confiscation which works as a proxy that captures IQL. The economy is hit by external shocks to demand for home goods and productivity shocks while its central bank seeks to stabilize inflation and output. In the long run, a lower IQL tends to discourage external liabilities. If there is a positive external demand shock, we observe an increase in output and real appreciation. The latter operates through two opposite channels. First, it directly increases the opportunity cost of leisure generating incentives to expand labor supply. Second, it reduces the real value of the debt denominated in foreign currency which