The butterfly effect of small open economies

The rational expectations equilibrium of a small open economy can be subject to indeterminacy if foreign monetary policy does not satisfy the Taylor principle. We study the implications of foreign induced indeterminacy in the two-country version of the sticky-price small open economy model. Our main finding is that 'smallness' is a property of the unique rational expectations equilibrium of the large economy, and not a general property of the small open economy model. If the large economy fails to anchor expectations, shocks to the small economy can affect the large one. This form of indeterminacy gives rise to a 'butterfly effect'. Additional assumptions are required to preserve the 'smallness' of the small economy.