RDP 2007-06: The Butterfly Effect of Small Open Economies 5. Conclusion

This paper studies some implications of indeterminacy of the rational expectations equilibrium for a small open economy. With a version of the canonical sticky-price small open economy model, we find that indeterminacy in the large economy can increase the volatility of the small economy as it exposes the small economy to endogenous volatility. We show that a plausible monetary policy response in this situation is likely to involve a more aggressive response to deviations of inflation from the target and of output from potential. We also show that fundamental shocks for the small economy can act like non-fundamental shocks for the large economy.

But, perhaps more importantly, we find that ‘smallness’ is not a general property of the model but, instead, a property of the large economy's unique determination. This finding, we think, is methodologically important, since even if the ‘butterfly effect’ is thought to be merely an inconvenient theoretical result, it still requires careful consideration of the assumptions underpinning small open economy models. In particular, smallness can be guaranteed in one of two ways. First, by limiting the analysis to unique solutions which, in the case of the model presented here, can be achieved by satisfying the Taylor principle. Or, second, by restricting the information available to agents in the large economy to the set of information in that economy alone.