Identifying monetary policy in a small open economy under flexible exchange rates

Abstract

Previous empirical study on the effects of monetary policy shocks in small open economies has generated puzzling dynamic responses in various macroeconomic variables. This paper argues that these puzzles derive from an identification of monetary policy that is inappropriate for such economies. To remedy this, it is proposed that a structural model be estimated to explicitly account for the features of the small open economy. Such a model is applied to Canada with tightly estimated results overall. The dynamic responses to the identified monetary policy shock are consistent with standard theory and highlight the exchange rate as a transmission mechanism.