Stabilizing Inflation in the Open Economy

Abstract

Optimal monetary policy in the open economy continues to be of interest to the profession, as in Benavie and Froyen [1], and price level stabilization has been investigated by Bradley and Jansen [4], Marquis and Cunningham [13], and Fischer [6], among many others. Price level stabilization has also been investigated in the monetary policy literature by, for example, Black [2] or Black and Gavin [3]. The academic literature has included analysis of price level stabilization in a variety of macroeconomic frameworks ranging from overlapping generations models to equilibrium business cycle models and Keynesian contracting models. What has been lacking, however, is a rigorous analysis of price level stabilization in the open economy. This apparent omission is interesting because the most famous historical application of price level targeting occurred in the 1930s in Sweden a small open economy.' In this paper we carefully examine the effectiveness of price level or inflation stabilization in the small open economy.2 Employing an equilibrium business cycle model with differentially informed agents, we find that when shocks to the economy exhibit some persistence, inflation stabilization has favorable output stabilization properties relative to alternative monetary policies. Further, these beneficial aspects of inflation stabilization exist whether or not agents contemporaneously observe the money stock. The only instance in which inflation stabilization policy is not preferred is when all shocks to the economy are strictly temporary shocks and when uninformed agents can not observe the money stock contemporaneously. Finally, in all instances we find that price level stabilization is preferred, from a macroeconomic stabilization perspective, to exchange