Openness and the (inverted) aggregate demand logic

I build a small open economy version of the Calvo-type staggered price-setting model with limited asset market participation, and I show that the inverted aggregate demand logic is less likely to apply to small open economies. The equilibrium dynamics of the model are reduced to a representation in the output gap and domestic inflation, and depend on the degree of asset market participation in a non-linear way. If asset market participation decreases above a certain threshold, the relationship between the real interest rate and aggregate output strengthens. Below this threshold, the link between the real interest rate and aggregate demand inverts: aggregate domestic output contracts in response to a decrease in the real interest rate. Policy rules have to satisfy an inverted Taylor Principle to ensure a unique equilibrium in this type of economy. When an economy is open, the ‘standard’ Taylor Principle is strictly more likely to apply. The Taylor Principle is restored regardless of the level of asset market participation when the redistributive dividend tax rate, or the share of domestic firms under foreign ownership, exceeds a certain threshold.
 
Keywords: Taylor Principle, openness, indeterminacy, limited asset market participation.
JEL classification: E44, E52, F41.

Working paper no. 436