- Email: [email protected]
Financial openness, nontradable inflation and optimal monetary policy
Economics Letters 117 (2012) 782–785
Contents lists available at SciVerse ScienceDirect
Economics Letters journal homepage: www.elsevier.com/locate/ecolet
Financial openness, nontradable inflation and optimal monetary policy Emmanuel K.K. Lartey ∗ Department of Economics, California State University, Fullerton, 800 N. State College Blvd, Fullerton, CA 92834, United States
article
info
Article history: Received 21 April 2012 Received in revised form 22 August 2012 Accepted 27 August 2012 Available online 4 September 2012
abstract This paper examines capital inflow dynamics for varying degrees of financial openness under a Taylortype rule. The findings show that higher openness generates a more sensitive response in nontradable inflation, and that optimal monetary policy varies with the degree of openness. © 2012 Elsevier B.V. All rights reserved.
JEL classification: E52 F40 F41 Keywords: Financial openness Capital inflows Real exchange rate
1. Introduction The maintenance of macroeconomic stability and external competitiveness during periods of rising capital inflow is essential. Yet, research on the role of monetary policy in the dynamics generated by capital inflow in emerging economies within the context of Dutch disease effects is scanty. Lartey (2008a) finds that, in general, the optimal policy rule in such cases is characterized by a somewhat aggressive reaction to nontradable inflation. Lartey (2008b), however, shows within a real business cycle framework that, under a greater degree of financial openness, nontradable prices increase by a greater magnitude following an increase in capital inflow. The main questions that arise are as follows: (1) will nontradable inflation be more sensitive to monetary policy under a higher degree of financial openness, and (2) will the optimal policy rule under a higher degree of financial openness imply a more aggressive reaction to nontradable inflation? This study examines these questions. 2. The model 2.1. Households There is a continuum of households of measure unity. The 1+ν ∞ t 1 1−σ L C − ψ 1t+ν , household maximizes the utility: Et t =0 β 1−σ t
∗
Tel.: +1 657 278 7298; fax: +1 657 278 3097. E-mail address: [email protected].
0165-1765/$ – see front matter © 2012 Elsevier B.V. All rights reserved. doi:10.1016/j.econlet.2012.08.043
with σ , ν, ψ > 0, where C is consumption and L is labor supply. The consumption index is an aggregate of nontradable good
1 θ−1 1 (CN ) and tradable good (CT ); Ct = γ θ (CT ,t ) θ + (1 − γ ) θ θ −1 θ (CN ,t ) θ θ −1 , γ ∈ 0, 1 , θ > 0. Consumption of nontradable 1 ϑ ϑ−1 goods is differentiated, with a subindex, CN = ( 0 CN (i) ϑ di) ϑ−1 , ϑ > 1. The tradable consumption good is a composite of home 1 ρh −1 (CH ,t ) and foreign (CF ,t ) tradable goods, CT ,t = γh ρh CH ,t ρh + 1 ρh −1 ρh 1 − γh ρh CF ,t ρh ρh −1 , γh ∈ 0, 1 , ρh > 0. The corresponding 1 1−ρh 1−ρ h , price index is PTC ,t = γh (PT ,t )1−ρh + 1 − γh PCF ,t where PCF ,t is the price of the foreign tradable consumption good and PT is the price of the domestic tradable good. The consumer price index is Pt =
(
1 γ (PTC ,t )1−θ + (1 − γ )(PN ,t )1−θ 1−θ ; PN =
1
1
PN (i)1−ϑ di) 1−ϑ is the price subindex for the nontradable good, and PTC is the price of the tradable consumption good. Optimal allocation of expenditure between the two goods yields CT ,t = 0
γ(
PTC ,t −θ Ct Pt
P
and CN ,t = (1 − γ )( PN ,t )−θ Ct . t The household’s budget constraint is
)
Bt +1 + εt B∗t +1 +
κ
2
(εt B∗t +1 )2 + Pt Ct + Vt xt +1
= (1 + it )Bt + εt (1 + i∗t )B∗t + (Vt + Dt )xt + Wt Lt + τt + Πt .
(1)
Bt is domestic bonds, B∗t is foreign bonds, and xt represents shares of the domestic tradable sector firm. κ2 (B∗t +1 )2 is the cost of adjustment for foreign bonds, τt is the rebate of financial intermediation
E.K.K. Lartey / Economics Letters 117 (2012) 782–785
fees, Vt is the price of a claim to the tradable firm, Dt is the dividends issued by the tradable firm, and it and i∗t are nominal interest rates on bonds in home and foreign currencies, respectively. Wt is the nominal wage, εt is the nominal exchange rate, and Πt represents profits from the nontradable sector. The household maximizes utility subject to the budget constraint, and the optimality conditions are
Pt Ct−σ = β Et Ct−σ +1 (1 + it +1 ) P
Kt +1 , It and LT ,t respectively are
α PT ,t +1
Et Λt +1
−φ
,
It + 1 Kt + 1
1+φ
(2)
P I ,t
−σ
Ct
Ct−σ
Pt
Pt
Vt = β E t Wt
εt B∗t +1
Pt ∗ ε ( 1 + i ) = β Et Ct−σ , t +1 +1 t +1
(3)
(1 − α)
P t +1
Ct−σ +1 (Vt +1
+ D t +1 )
Pt P t +1
,
(4)
= ψ Lνt .
(5)
2.2. Firms
2.2.1. Tradable sector The tradable sector consists of investment and production units. Capital is used in the tradable sector only; hence the nontradable good is produced using labor.1 The total domestic labor supply is L = LT + LN , where LT is tradable sector labor and LN is nontradable sector labor. Investment unit. The investment unit combines home investment (IH ) and foreign investment (IF ) to produce investment (I ) to maintain and accumulate capital, using the technology It =
ρ−1 ρ−1 ρ 1 1 µ ρ (IH ,t ) ρ + (1 − µ) ρ (IF ,t ) ρ ρ−1 , where ρ > 0 and 0 < µ ≤ 1. The unit cost of investment is PI ,t = µ(PT ,t )1−ρ + (1 − µ) 1 (PTF,t )1−ρ 1−ρ ; PT ,t is the price of the domestic tradable good and
PTF,t is the price of foreign investment in domestic currency, where PTF,t = εt PTF,∗t and PTF,∗t is the foreign currency price.2 The unit’s minimization problem is min PT ,t IH ,t + PTF,t IF ,t 1
ρ−1 ρ
IF ,t = (1 − µ) I H ,t = µ
1
ρ−1 ρ
ρ−ρ 1
PT ,t P I ,t
It .
It ,
(6)
(7)
s − Wt LT ,s , subject to Kt +1 = It + (1 − δ)Kt . The optimal choices for
1 This assumption makes possible the generation of a capital-inflow-induced boom in the tradable sector in order to capture the Dutch disease phenomenon. See Lartey (2008a) for details on the Dutch disease. 2 An increase in the import content of investment represents capital inflow.
σ Ct Cs
Wt
−δ
+ Qt +1 (1 − δ) = Qt ,
(8)
= Qt ,
(9)
.
P T ,t
(10)
YN ,t (i) LN ,t (i)
=
Wt P N ,t
,
(11)
is the real marginal cost. Firms set prices á la Calvo where mc = MC PN (1983), and (1 − ϕ) is the probability of changing the optimal price P˜ N ,t (i). The optimal pricing condition is
P˜ N ,t (i) =
ϑ 1−ϑ
Et
∞
ϕ k Λt +k MCt +k YN ,t +k (i)
k=0
Et
∞
.
(12)
ϕ k Λt +k YN ,t +k (i)
k =0
2.2.3. Open economy expressions The small open economy takes foreign variables as given. The εt P ∗
real exchange rate, et = P t , is the ratio of the price of the foreign t consumption basket to the domestic one. An export demand curve ξ is specified as Xt = et YtF ; ξ > 0, where YtF is the aggregate output in the foreign economy.
ω = (1 + r ss ) 1 + πN ,t π N
Production unit. The production unit produces a tradable good using technology YT ,t = exp {at } Ktα LT ,t 1−α ; 0 < α < 1, where at is a productivity shock. The unit maximizes thepresent discounted ∞ φ Is 2 value of dividends,3 Et s=t Λs PT ,s YT ,s − PI ,s Is + 2 ( K − δ) Ks
3 β s−t
−δ
Kt + 1
2
(1 + it +1 )
= It ,
−ρ
P I ,t
−ρ
Kt + 1
It + 1
The benchmark policy is a Taylor-type interest rate rule given
+ (1 − µ) ρ (IF ,t )
PTF,t
=
It + 1
2
by
and the optimal choices are
It
− P I ,t + 1
φ
2.3. Monetary policy
{IH , IF }
s.t . µ ρ (IH ,t )
LT ,t
Kt + 1
2.2.2. Nontradable sector There is a continuum of monopolistically competitive firms of measure unity, each producing with technology YN ,t (i) = exp {zt } LN ,t (i), where zt is a stochastic productivity parameter. The static efficiency condition for labor demand is mct
Production occurs in two sectors: tradable and nontradable.
YT ,t
YT ,t +1
−δ
Kt
t +1
Ct−σ εt + κ
783
= Λs for s = t , t + 1, t + 2, . . . is the stochastic discount factor.
gdpt gdpss
ωgdp
et e t −1
ωe
,
(13)
where ωπN > 1, ωgdp > 0, and ωe ≥ 0 are the reaction coefficients on nontradable inflation, GDP, and real exchange rate depreciation, respectively, and r ss and gdpss are the steady-state real interest rate and GDP, respectively. 3. Model dynamics and financial openness The choice of parameter values is as follows. The household discount factor β = 0.99, the share of capital in tradable good production is α = 0.33, the depreciation rate δ is 0.05, and the inverse of elasticity of labor supply ν = 0.83. I set κ = 0.01, ρh = 0.55, γh = 0.4, ψ = 1, γ = 0.45, σ = 2, and the probability of price non-adjustment ϕ = 0.75. I assign µ = 0.5 and ρ = 1.5. For the benchmark monetary policy parameters, ωπN = 1.5, ωgdp = 0.5 and ωe = 0.45. I examine the behavior of nontradable inflation, sectoral output, and the real exchange rate following an increase in capital inflow under different degrees of openness, captured by different values of µ (0.5, 0.25, 0.1). As Fig. 1 shows, the greater the degree of
784
E.K.K. Lartey / Economics Letters 117 (2012) 782–785
Fig. 1. Impulse responses under the benchmark Taylor rule: µ = 0.5 (circles), µ = 0.25 (triangles), µ = 0.1 (squares).
Fig. 2. Impulse responses under the optimal rule: µ = 0.5 (circles), µ = 0.25 (triangles), µ = 0.1 (squares).
openness (lower value of µ), the greater the increase in the capital stock, and hence the expansion in tradable output and tradable consumption. Nontradable output, on the other hand, contracts as nontradable consumption decreases due to the policy rule.
Nontradable inflation therefore declines, with the magnitude being higher the greater the openness. Thus, higher openness generates a greater response in nontradable inflation, and consequently a greater real exchange rate depreciation.
E.K.K. Lartey / Economics Letters 117 (2012) 782–785
785
Fig. 3. Impulse responses under the benchmark rule (circles) and the optimal rule (squares) for µ = 0.1.
4. Optimal policy rule A welfare analysis is performed to determine the optimal policy rule under varying degrees of openness. The welfare function is Wt =
C
1−σ
1−σ
−
σ 2
C
1+ν
−ψ 1−σ
L
1+ν
E (Cˆ t2 ) −
+C ψν 2
1−σ
L
E (Cˆ t ) − ψ L
1+ν
1+ν
E (Lˆ t )
E (Lˆ 2t ),
(14)
where C and L are steady-state values of consumption and labor, respectively, and variables with a hat denote percentage deviations from the steady state. The policy maker maximizes the welfare function by choosing the reaction coefficients from a generalized Taylor rule given by
ω (1 + it +1 ) = (1 + it )ωi (1 + r ss ) 1 + πN ,t π N ωgdp ωe εt ωε et gdpt , × gdpss εt − 1 e t −1
inflation. Instead, a lower reaction coefficient on nontradable inflation is observed under a higher degree of openness. I evaluate the welfare criterion for the optimal rule under each case of openness considered and obtain, in absolute value, a welfare loss of 1.97, 1.86, and 1.83 for µ = 0.5, 0.25, and 0.1, respectively, which suggests welfare is increasing in the degree of openness under such rules. Fig. 2 plots the dynamics under the optimal rule for each case. Fig. 3 compares the dynamics under the benchmark and optimal policy rules when µ = 0.1. The optimal policy here delivers a moderate increase in labor supply, and prevents a decrease in total consumption. It also moderates the expansion in tradable output and consumption of tradables, while limiting the contraction in nontradables without inducing a magnified reduction in nontradable inflation. 5. Conclusions
(15)
where ωi ≥ 0 is the degree of interest rate smoothing and ωε is a reaction coefficient on nominal exchange rate depreciation; all other variables are as defined. The optimal reaction parameters are as follows: ωi = 0.75, ωπ N = 2.82 for µ = 0.5; ωi = 0.75, ωπ N = 2.70 for µ = 0.25; and ωi = 0.75, ωπ N = 2.58 for µ = 0.1, with ωgdp = 0, ωε = 0, ωe = 0 in all cases. The optimal policy, therefore, varies with the degree of openness. In general, it is characterized by a significant degree of interest rate smoothing, nominal exchange rate flexibility, and strong reaction to nontradable inflation, which decreases with openness. This is a very interesting result given the dynamics under the benchmark rule, in that the anticipated increase in nontradable consumption should rise with openness, and therefore trigger a stronger reaction to nontradable
This paper shows that nontradable inflation is more responsive to monetary policy under a greater degree of financial openness in an economy that is subject to an increase in capital inflow, and where the policy maker aims at controlling nontradable inflation and the concomitant appreciation of the real exchange rate. The results also indicate that the optimal monetary policy varies with the degree of financial openness. References Calvo, Guillermo, 1983. Staggered prices in a utility-maximizing framework. Journal of Monetary Economics 12, 383–398. Lartey, Emmanuel K.K., 2008a. Capital inflows, Dutch disease effects and monetary policy in a small open economy. Review of International Economics 16 (5), 971–989. Lartey, Emmanuel K.K., 2008b. Capital inflows, resource reallocation and the real exchange rate. International Finance 11, 131–152.
Contents lists available at SciVerse ScienceDirect
Economics Letters journal homepage: www.elsevier.com/locate/ecolet
Financial openness, nontradable inflation and optimal monetary policy Emmanuel K.K. Lartey ∗ Department of Economics, California State University, Fullerton, 800 N. State College Blvd, Fullerton, CA 92834, United States
article
info
Article history: Received 21 April 2012 Received in revised form 22 August 2012 Accepted 27 August 2012 Available online 4 September 2012
abstract This paper examines capital inflow dynamics for varying degrees of financial openness under a Taylortype rule. The findings show that higher openness generates a more sensitive response in nontradable inflation, and that optimal monetary policy varies with the degree of openness. © 2012 Elsevier B.V. All rights reserved.
JEL classification: E52 F40 F41 Keywords: Financial openness Capital inflows Real exchange rate
1. Introduction The maintenance of macroeconomic stability and external competitiveness during periods of rising capital inflow is essential. Yet, research on the role of monetary policy in the dynamics generated by capital inflow in emerging economies within the context of Dutch disease effects is scanty. Lartey (2008a) finds that, in general, the optimal policy rule in such cases is characterized by a somewhat aggressive reaction to nontradable inflation. Lartey (2008b), however, shows within a real business cycle framework that, under a greater degree of financial openness, nontradable prices increase by a greater magnitude following an increase in capital inflow. The main questions that arise are as follows: (1) will nontradable inflation be more sensitive to monetary policy under a higher degree of financial openness, and (2) will the optimal policy rule under a higher degree of financial openness imply a more aggressive reaction to nontradable inflation? This study examines these questions. 2. The model 2.1. Households There is a continuum of households of measure unity. The 1+ν ∞ t 1 1−σ L C − ψ 1t+ν , household maximizes the utility: Et t =0 β 1−σ t
∗
Tel.: +1 657 278 7298; fax: +1 657 278 3097. E-mail address: [email protected].
0165-1765/$ – see front matter © 2012 Elsevier B.V. All rights reserved. doi:10.1016/j.econlet.2012.08.043
with σ , ν, ψ > 0, where C is consumption and L is labor supply. The consumption index is an aggregate of nontradable good
1 θ−1 1 (CN ) and tradable good (CT ); Ct = γ θ (CT ,t ) θ + (1 − γ ) θ θ −1 θ (CN ,t ) θ θ −1 , γ ∈ 0, 1 , θ > 0. Consumption of nontradable 1 ϑ ϑ−1 goods is differentiated, with a subindex, CN = ( 0 CN (i) ϑ di) ϑ−1 , ϑ > 1. The tradable consumption good is a composite of home 1 ρh −1 (CH ,t ) and foreign (CF ,t ) tradable goods, CT ,t = γh ρh CH ,t ρh + 1 ρh −1 ρh 1 − γh ρh CF ,t ρh ρh −1 , γh ∈ 0, 1 , ρh > 0. The corresponding 1 1−ρh 1−ρ h , price index is PTC ,t = γh (PT ,t )1−ρh + 1 − γh PCF ,t where PCF ,t is the price of the foreign tradable consumption good and PT is the price of the domestic tradable good. The consumer price index is Pt =
(
1 γ (PTC ,t )1−θ + (1 − γ )(PN ,t )1−θ 1−θ ; PN =
1
1
PN (i)1−ϑ di) 1−ϑ is the price subindex for the nontradable good, and PTC is the price of the tradable consumption good. Optimal allocation of expenditure between the two goods yields CT ,t = 0
γ(
PTC ,t −θ Ct Pt
P
and CN ,t = (1 − γ )( PN ,t )−θ Ct . t The household’s budget constraint is
)
Bt +1 + εt B∗t +1 +
κ
2
(εt B∗t +1 )2 + Pt Ct + Vt xt +1
= (1 + it )Bt + εt (1 + i∗t )B∗t + (Vt + Dt )xt + Wt Lt + τt + Πt .
(1)
Bt is domestic bonds, B∗t is foreign bonds, and xt represents shares of the domestic tradable sector firm. κ2 (B∗t +1 )2 is the cost of adjustment for foreign bonds, τt is the rebate of financial intermediation
E.K.K. Lartey / Economics Letters 117 (2012) 782–785
fees, Vt is the price of a claim to the tradable firm, Dt is the dividends issued by the tradable firm, and it and i∗t are nominal interest rates on bonds in home and foreign currencies, respectively. Wt is the nominal wage, εt is the nominal exchange rate, and Πt represents profits from the nontradable sector. The household maximizes utility subject to the budget constraint, and the optimality conditions are
Pt Ct−σ = β Et Ct−σ +1 (1 + it +1 ) P
Kt +1 , It and LT ,t respectively are
α PT ,t +1
Et Λt +1
−φ
,
It + 1 Kt + 1
1+φ
(2)
P I ,t
−σ
Ct
Ct−σ
Pt
Pt
Vt = β E t Wt
εt B∗t +1
Pt ∗ ε ( 1 + i ) = β Et Ct−σ , t +1 +1 t +1
(3)
(1 − α)
P t +1
Ct−σ +1 (Vt +1
+ D t +1 )
Pt P t +1
,
(4)
= ψ Lνt .
(5)
2.2. Firms
2.2.1. Tradable sector The tradable sector consists of investment and production units. Capital is used in the tradable sector only; hence the nontradable good is produced using labor.1 The total domestic labor supply is L = LT + LN , where LT is tradable sector labor and LN is nontradable sector labor. Investment unit. The investment unit combines home investment (IH ) and foreign investment (IF ) to produce investment (I ) to maintain and accumulate capital, using the technology It =
ρ−1 ρ−1 ρ 1 1 µ ρ (IH ,t ) ρ + (1 − µ) ρ (IF ,t ) ρ ρ−1 , where ρ > 0 and 0 < µ ≤ 1. The unit cost of investment is PI ,t = µ(PT ,t )1−ρ + (1 − µ) 1 (PTF,t )1−ρ 1−ρ ; PT ,t is the price of the domestic tradable good and
PTF,t is the price of foreign investment in domestic currency, where PTF,t = εt PTF,∗t and PTF,∗t is the foreign currency price.2 The unit’s minimization problem is min PT ,t IH ,t + PTF,t IF ,t 1
ρ−1 ρ
IF ,t = (1 − µ) I H ,t = µ
1
ρ−1 ρ
ρ−ρ 1
PT ,t P I ,t
It .
It ,
(6)
(7)
s − Wt LT ,s , subject to Kt +1 = It + (1 − δ)Kt . The optimal choices for
1 This assumption makes possible the generation of a capital-inflow-induced boom in the tradable sector in order to capture the Dutch disease phenomenon. See Lartey (2008a) for details on the Dutch disease. 2 An increase in the import content of investment represents capital inflow.
σ Ct Cs
Wt
−δ
+ Qt +1 (1 − δ) = Qt ,
(8)
= Qt ,
(9)
.
P T ,t
(10)
YN ,t (i) LN ,t (i)
=
Wt P N ,t
,
(11)
is the real marginal cost. Firms set prices á la Calvo where mc = MC PN (1983), and (1 − ϕ) is the probability of changing the optimal price P˜ N ,t (i). The optimal pricing condition is
P˜ N ,t (i) =
ϑ 1−ϑ
Et
∞
ϕ k Λt +k MCt +k YN ,t +k (i)
k=0
Et
∞
.
(12)
ϕ k Λt +k YN ,t +k (i)
k =0
2.2.3. Open economy expressions The small open economy takes foreign variables as given. The εt P ∗
real exchange rate, et = P t , is the ratio of the price of the foreign t consumption basket to the domestic one. An export demand curve ξ is specified as Xt = et YtF ; ξ > 0, where YtF is the aggregate output in the foreign economy.
ω = (1 + r ss ) 1 + πN ,t π N
Production unit. The production unit produces a tradable good using technology YT ,t = exp {at } Ktα LT ,t 1−α ; 0 < α < 1, where at is a productivity shock. The unit maximizes thepresent discounted ∞ φ Is 2 value of dividends,3 Et s=t Λs PT ,s YT ,s − PI ,s Is + 2 ( K − δ) Ks
3 β s−t
−δ
Kt + 1
2
(1 + it +1 )
= It ,
−ρ
P I ,t
−ρ
Kt + 1
It + 1
The benchmark policy is a Taylor-type interest rate rule given
+ (1 − µ) ρ (IF ,t )
PTF,t
=
It + 1
2
by
and the optimal choices are
It
− P I ,t + 1
φ
2.3. Monetary policy
{IH , IF }
s.t . µ ρ (IH ,t )
LT ,t
Kt + 1
2.2.2. Nontradable sector There is a continuum of monopolistically competitive firms of measure unity, each producing with technology YN ,t (i) = exp {zt } LN ,t (i), where zt is a stochastic productivity parameter. The static efficiency condition for labor demand is mct
Production occurs in two sectors: tradable and nontradable.
YT ,t
YT ,t +1
−δ
Kt
t +1
Ct−σ εt + κ
783
= Λs for s = t , t + 1, t + 2, . . . is the stochastic discount factor.
gdpt gdpss
ωgdp
et e t −1
ωe
,
(13)
where ωπN > 1, ωgdp > 0, and ωe ≥ 0 are the reaction coefficients on nontradable inflation, GDP, and real exchange rate depreciation, respectively, and r ss and gdpss are the steady-state real interest rate and GDP, respectively. 3. Model dynamics and financial openness The choice of parameter values is as follows. The household discount factor β = 0.99, the share of capital in tradable good production is α = 0.33, the depreciation rate δ is 0.05, and the inverse of elasticity of labor supply ν = 0.83. I set κ = 0.01, ρh = 0.55, γh = 0.4, ψ = 1, γ = 0.45, σ = 2, and the probability of price non-adjustment ϕ = 0.75. I assign µ = 0.5 and ρ = 1.5. For the benchmark monetary policy parameters, ωπN = 1.5, ωgdp = 0.5 and ωe = 0.45. I examine the behavior of nontradable inflation, sectoral output, and the real exchange rate following an increase in capital inflow under different degrees of openness, captured by different values of µ (0.5, 0.25, 0.1). As Fig. 1 shows, the greater the degree of
784
E.K.K. Lartey / Economics Letters 117 (2012) 782–785
Fig. 1. Impulse responses under the benchmark Taylor rule: µ = 0.5 (circles), µ = 0.25 (triangles), µ = 0.1 (squares).
Fig. 2. Impulse responses under the optimal rule: µ = 0.5 (circles), µ = 0.25 (triangles), µ = 0.1 (squares).
openness (lower value of µ), the greater the increase in the capital stock, and hence the expansion in tradable output and tradable consumption. Nontradable output, on the other hand, contracts as nontradable consumption decreases due to the policy rule.
Nontradable inflation therefore declines, with the magnitude being higher the greater the openness. Thus, higher openness generates a greater response in nontradable inflation, and consequently a greater real exchange rate depreciation.
E.K.K. Lartey / Economics Letters 117 (2012) 782–785
785
Fig. 3. Impulse responses under the benchmark rule (circles) and the optimal rule (squares) for µ = 0.1.
4. Optimal policy rule A welfare analysis is performed to determine the optimal policy rule under varying degrees of openness. The welfare function is Wt =
C
1−σ
1−σ
−
σ 2
C
1+ν
−ψ 1−σ
L
1+ν
E (Cˆ t2 ) −
+C ψν 2
1−σ
L
E (Cˆ t ) − ψ L
1+ν
1+ν
E (Lˆ t )
E (Lˆ 2t ),
(14)
where C and L are steady-state values of consumption and labor, respectively, and variables with a hat denote percentage deviations from the steady state. The policy maker maximizes the welfare function by choosing the reaction coefficients from a generalized Taylor rule given by
ω (1 + it +1 ) = (1 + it )ωi (1 + r ss ) 1 + πN ,t π N ωgdp ωe εt ωε et gdpt , × gdpss εt − 1 e t −1
inflation. Instead, a lower reaction coefficient on nontradable inflation is observed under a higher degree of openness. I evaluate the welfare criterion for the optimal rule under each case of openness considered and obtain, in absolute value, a welfare loss of 1.97, 1.86, and 1.83 for µ = 0.5, 0.25, and 0.1, respectively, which suggests welfare is increasing in the degree of openness under such rules. Fig. 2 plots the dynamics under the optimal rule for each case. Fig. 3 compares the dynamics under the benchmark and optimal policy rules when µ = 0.1. The optimal policy here delivers a moderate increase in labor supply, and prevents a decrease in total consumption. It also moderates the expansion in tradable output and consumption of tradables, while limiting the contraction in nontradables without inducing a magnified reduction in nontradable inflation. 5. Conclusions
(15)
where ωi ≥ 0 is the degree of interest rate smoothing and ωε is a reaction coefficient on nominal exchange rate depreciation; all other variables are as defined. The optimal reaction parameters are as follows: ωi = 0.75, ωπ N = 2.82 for µ = 0.5; ωi = 0.75, ωπ N = 2.70 for µ = 0.25; and ωi = 0.75, ωπ N = 2.58 for µ = 0.1, with ωgdp = 0, ωε = 0, ωe = 0 in all cases. The optimal policy, therefore, varies with the degree of openness. In general, it is characterized by a significant degree of interest rate smoothing, nominal exchange rate flexibility, and strong reaction to nontradable inflation, which decreases with openness. This is a very interesting result given the dynamics under the benchmark rule, in that the anticipated increase in nontradable consumption should rise with openness, and therefore trigger a stronger reaction to nontradable
This paper shows that nontradable inflation is more responsive to monetary policy under a greater degree of financial openness in an economy that is subject to an increase in capital inflow, and where the policy maker aims at controlling nontradable inflation and the concomitant appreciation of the real exchange rate. The results also indicate that the optimal monetary policy varies with the degree of financial openness. References Calvo, Guillermo, 1983. Staggered prices in a utility-maximizing framework. Journal of Monetary Economics 12, 383–398. Lartey, Emmanuel K.K., 2008a. Capital inflows, Dutch disease effects and monetary policy in a small open economy. Review of International Economics 16 (5), 971–989. Lartey, Emmanuel K.K., 2008b. Capital inflows, resource reallocation and the real exchange rate. International Finance 11, 131–152.