CXO

Incomplete Markets, Small Open Economy Monetary Policy And Equilibrium Determinacy

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The authors propose an alternative and simple small open economy model with incomplete international asset markets. Asset market incompleteness breaks the "Monetary-policy isomorphism" between the small open economy and its closed economy limit; and the real exchange rate is a fundamental variable in determining the equilibrium. This explicit equilibrium exchange rate channel has an endogenous "Cost-push" monetary-policy trade-off interpretation. Moreover, their model nests the canonical two-equation closed and small open economies as special cases. They then show that established lessons on local stability of rational expectations equilibrium under alternative monetary policies are reversed when the economy cannot completely insure country-specific risks.