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Forward Guidance in Small Open Economy

André, Marine-Charlotte and Traficante, Guido (2020): Forward Guidance in Small Open Economy.

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Abstract

We examine forward guidance in a small open economy New Keynesian model. In a setup where forward guidance duration is known with certainty, we show that the elasticity of in ation with respect to the real exchange rate is a key variable in attenuating the forward guidance puzzle. Then we consider a credible forward guidance regime which is adopted stochastically, in normal times or under a liquidity trap. Compared to closed economy, forward guidance turns out to be more expansionary in open economy and the real exchange rate is a key variable driving this result. In particular, the response of output and inflation is amplified when aggregate supply is negatively related to the real exchange rate.

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