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ANATOMIZING INCOMPLETE-MARKETS SMALL OPEN ECONOMIES: POLICY TRADE-OFFS AND EQUILIBRIUM DETERMINACY

Published online by Cambridge University Press:  05 May 2015

Jaime Alonso-Carrera  and
Timothy Kam
Jaime Alonso-Carrera
Affiliation:
Universidade de Vigo
Timothy Kam*
Affiliation:
The Australian National University
*
Address correspondence to: Timothy Kam, School of Economics, H.W. Arndt Building 25a, the Australian National University, A.C.T. 0200, Australia; e-mail: timothy.kam@anu.edu.au.
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Abstract

We propose a simple incomplete-markets small-open-economy model that is amenable to analytical dissection of its policy-relevant mechanisms. In contrast to its complete-markets limit, the equilibrium real exchange rate is irreducible from the incomplete-markets equilibrium. Market incompleteness exacerbates the domestic-inflation and output-gap monetary-policy trade-off in two ways: its steepness and its resulting endogenous cost-push to the trade-off. The latter depends on an equilibrium combination of structural shocks and on agents' beliefs of future events. Thus, in comparison to its complete-markets and closed-economy limits, standard Taylor-type rules are less capable of inducing determinate rational expectations equilibrium in our environment. Despite the larger policy trade-off under incomplete markets, simple policies that also respond to exchange-rate growth are able to manage expectations that drive the endogenous cost-push term. However, policies that respond directly to expectations may turn out to exacerbate the cost-push trade-off further, and thus, to be more likely to fuel self-fulfilling multiple or unstable equilibria.

Keywords

Incomplete MarketsMonetary Policy IsomorphismExchange RateEquilibrium Determinacy
Type
Articles
Information
Macroeconomic Dynamics , Volume 20 , Issue 4 , June 2016 , pp. 1022 - 1050
Copyright
Copyright © Cambridge University Press 2015 

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