The Macroeconomic Effects of Positive Trend Inflation in a Small Open Economy

ABSTRACT

The existing New Keynesian open economy literature tends to make the simplifying assumption that there is no trend inflation. In this paper, we reformulate the standard open economy model to account for positive trend inflation. We then employ the model to understand the effects of macroeconomic shocks in a small open economy when trend inflation is positive. Our main finding is that allowing for trend inflation significantly affects the dynamics of the model through real exchange rate dynamics rather than the slope of the New Keynesian Philips Curve. Specifically, higher trend inflation induces modestly more persistent real exchange rates’ responses to the shocks. Further incorporation of trend inflation in an open economy enables us to discuss the Purchasing Power Parity and Delayed Overshooting Puzzles.

KEYWORDS:

• Trend Inflation
• Small Open Economy
• New Keynesian models
• New Keynesian Phillips Curve
• Real Exchange Rate

JEL CLASSIFICATION:

• E31
• E52
• F41

Acknowledgments

We thank Engin Kara for helpful comments.

Disclosure statement

There is no financial interest or benefit from the application of our research.

Notes

¹ Variables with a subscript $i\in$ [0,1] indicate that those variables belong to country i. Variables without any index notation indicate that the variables belong to the domestic economy. Variables representing the world economy are indicated by a star superscript.

² The superscript hat shows the log-linearization of any variable from its steady state.

³ It is calculated as the first-order difference of equation 15 in Gali and Monacelli (2005, pg 713).

⁴ See appendix for more detailed derivation.

⁵ HL is the number of periods at which the effect of shock on the real exchange rate reduces by half; and QL is the number of periods at which the effect of shock on the real exchange rate reduces by quarter; and UL is the number of period at which the real exchange rate reaches its peak (or bottom).