Optimal Devaluations

Abstract

The paper analyzes optimal policy in a simple small open economy model with price setting frictions. In particular, the paper studies the optimal response of the nominal exchange rate following a terms-of-trade shock. The paper departs from the New Keynesian (NK) literature in that it explicitly models internationally traded commodities as intermediate inputs in the production of local final goods and assume that the small open economy takes this price as given. This modification is not only in line with the long standing tradition of small open economy models, but also changes the optimal movements in the exchange rate. In contrast with the recent Small Open Economy NK literature, the model in this paper is able to reproduce the comovement between the nominal exchange rate and the price of exports, as it has been documented in the commodity currencies literature. Although the paper shows that there are preferences for which price stability is optimal even without flexible fiscal instruments, the model suggests that more attention should be given to the coordination between monetary and fiscal policy (taxes) in small open economies that are heavily dependent on exports of commodities. The model the paper proposes is a useful framework to study fear of floating.